Table ofContents

 

 

 

**UNITEDSTATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

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

** **

**For the quarterly period ended March 31, 2010**

** **

**OR**

** **

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

** **

**For the transition period from             to            **

 

**Commission File Number 0-28312**

 

**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.**

(Exact name of registrant as specified in its charter)

 

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

 

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

 

**(870) 741-7641**

(Registrant’s telephone number, including area code)

 

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

 

Indicate by check markwhether the registrant has submitted electronically and posted on its corporateWeb site, if any, every Interactive Data File required to be submitted andposted pursuant to Rule 405 of Regulation S-T during the preceding 12months (or for such shorter period that the registrant was required to submitand post such files).  Yes   o  No  o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer, or a smaller reporting company.  See the definitions of “large acceleratedfiler,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2of the Exchange Act.  (Check one):

 

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

 

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

 

Indicate the number of shares outstanding of each ofthe issuer’s classes of common stock, as of the latest practicable date:  As of May 4, 2010, there were issued andoutstanding 4,846,785 shares of the Registrant’s Common Stock, par value $.01per share.

 

 

 

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

 

**TABLE OF CONTENTS**

 
| ** **        | ** **                                                                                                                                                                  | **Page** |
|-------------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|----------|
|              |                                                                                                                                                                        |     |
|              | **Financial  Information**                                                                                                                                                  |     |
|              | ** **                                                                                                                                                                  |     |
| Item 1.           | Condensed Consolidated Financial  Statements                                                                                                                                |     |
|              |                                                                                                                                                                        |     |
|              | Condensed  Consolidated Statements of Financial Condition as of March 31, 2010 and  December 31, 2009 (unaudited)                                                 | 1        |
|              |                                                                                                                                                                        |     |
|              | Condensed  Consolidated Statements of Operations for the three months ended  March 31, 2010 and 2009 (unaudited)                                                       | 2        |
|              |                                                                                                                                                                        |     |
|              | Condensed Consolidated Statement of Stockholders’  Equity for the three months ended March 31, 2010 (unaudited)                                                   | 3        |
|              |                                                                                                                                                                        |     |
|              | Condensed Consolidated Statements of Cash Flows for  the three months ended March 31, 2010 and 2009 (unaudited)                                                        | 4        |
|              |                                                                                                                                                                        |     |
|              | Notes to Unaudited Condensed Consolidated Financial  Statements                                                                                                             | 6        |
|              |                                                                                                                                                                        |     |
| Item 2.           | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                                                 | 17       |
|              |                                                                                                                                                                        |     |
| Item 3.           | Quantitative  and Qualitative Disclosures About Market Risk                                                                                                                 | 39       |
|              |                                                                                                                                                                        |     |
| Item 4.           | Controls and  Procedures                                                                                                                                                    | 39       |
|              |                                                                                                                                                                        |     |
| **Part II.** | **Other Information**                                                                                                                                                       |     |
|              |                                                                                                                                                                        |     |
| Item 1.           | Legal Proceedings                                                                                                                                                           | 40       |
| Item 1A.          | Risk Factors                                                                                                                                                                | 40       |
| Item 2.           | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                                                                | 46       |
| Item 3.           | Defaults  Upon Senior Securities                                                                                                                                            | 46       |
| Item 4.           | Removed and Reserved                                                                                                                                                        | 46       |
| Item 5.           | Other Information                                                                                                                                                           | 46       |
| Item 6.           | Exhibits                                                                                                                                                                    | 46       |
|              |                                                                                                                                                                        |     |
| **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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**Part I.   Financial Information**

 

**Item 1.  Financial Statements.**

 

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

**CONDENSEDCONSOLIDATED STATEMENTS OF FINANCIAL CONDITION**

(In thousands, except share data)

(Unaudited)

 
| ** **                                                                                                                                                                                    | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                    | ** ** | **2010**           | ** ** | **2009**              | ** ** |
| ASSETS                                                                                                                                                                                        |       |               |       |                  |       |
|                                                                                                                                                                                          |       |               |       |                  |       |
| Cash and cash equivalents                                                                                                                                                                     |       | $                  | 29,387     |                  | $          | 22,149 |   |
| Investment securities held to maturity                                                                                                                                                        |       | 119,262            |       | 135,531               |       |
| Federal Home Loan Bank stock                                                                                                                                                                  |       | 2,422              |       | 3,125                 |       |
| Loans receivable, net of allowance of $32,652 and  $32,908                                                                                                                                    |       | 460,104            |       | 481,542               |       |
| Loans held for sale                                                                                                                                                                           |       | 395                |       | 1,012                 |       |
| Accrued interest receivable                                                                                                                                                                   |       | 3,672              |       | 4,229                 |       |
| Real estate owned, net                                                                                                                                                                        |       | 33,623             |       | 35,155                |       |
| Office properties and equipment, net                                                                                                                                                          |       | 23,236             |       | 23,567                |       |
| Cash surrender value of life insurance                                                                                                                                                        |       | 21,424             |       | 21,226                |       |
| Prepaid expenses and other assets                                                                                                                                                             |       | 3,404              |       | 3,534                 |       |
|                                                                                                                                                                                          |       |               |       |                  |       |
| TOTAL ASSETS                                                                                                                                                                                  |       | $                  | 696,929    |                  | $          | 731,070 |   |
|                                                                                                                                                                                          |       |               |       |                  |       |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                     |       |               |       |                  |       |
|                                                                                                                                                                                          |       |               |       |                  |       |
| LIABILITIES:                                                                                                                                                                                  |       |               |       |                  |       |
| Deposits                                                                                                                                                                                      |       | $                  | 613,104    |                  | $          | 624,624 |   |
| Other borrowings                                                                                                                                                                              |       | 35,526             |       | 59,546                |       |
| Advance payments by borrowers for taxes and  insurance                                                                                                                                        |       | 905                |       | 695                   |       |
| Other liabilities                                                                                                                                                                             |       | 3,395              |       | 2,905                 |       |
| Total liabilities                                                                                                                                                                             |       | 652,930            |       | 687,770               |       |
|                                                                                                                                                                                          |       |               |       |                  |       |
| STOCKHOLDERS’ EQUITY:                                                                                                                                                                    |       |               |       |                  |       |
| Preferred stock, no par value, 5,000,000 shares  authorized; Series A fixed rate cumulative perpetual; liquidation  preference of $1,000 per share; 16,500 shares issued and outstanding |       | $                  | 16,211     |                  | $          | 16,195 |   |
| Common stock, $.01 par value, 20,000,000 shares  authorized, 10,307,502 shares issued, 4,846,785 shares outstanding                                                                           |       | 103                |       | 103                   |       |
| Additional paid-in capital                                                                                                                                                                    |       | 56,986             |       | 56,986                |       |
| Retained earnings-substantially restricted                                                                                                                                                    |       | 41,317             |       | 40,634                |       |
|                                                                                                                                                                                          |       | 114,617            |       | 113,918               |       |
| Treasury stock, at cost, 5,460,717 shares at  March 31, 2010 and December 31, 2009                                                                                                  |       | (70,618            | )          | (70,618               | )          |
| Total stockholders’ equity                                                                                                                                                               |       | 43,999             |       | 43,300                |       |
|                                                                                                                                                                                          |       |               |       |                  |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                               |       | $                  | 696,929    |                  | $          | 731,070 |   |

 

See notes to unaudited condensed consolidated financial statements.

 

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

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

(In thousands, except share data)

(Unaudited)

 
| ** **                                                           | ** ** | **Three Months Ended** | ** ** |
|----------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                           | ** ** | **March 31****,** | ** ** | **March 31****,** | ** ** |
| ** **                                                           | ** ** | **2010**               | ** ** | **2009** | ** ** |
|                                                                 |       |                   |       |   |   |
| INTEREST INCOME:                                                     |       |                   |       |   |   |
| Loans receivable                                                     |       | $                      | 6,829      |   | $ | 7,555 |   |
| Investment securities:                                               |       |                   |       |   |   |
| Taxable                                                              |       | 1,315                  |       | 1,348 |   |
| Nontaxable                                                           |       | 272                    |       | 216 |   |
| Other                                                                |       | 15                     |       | 3 |   |
| Total interest income                                                |       | 8,431                  |       | 9,122 |   |
|                                                                 |       |                   |       |   |   |
| INTEREST EXPENSE:                                                    |       |                   |       |   |   |
| Deposits                                                             |       | 2,549                  |       | 3,781 |   |
| Other borrowings                                                     |       | 242                    |       | 645 |   |
| Total interest expense                                               |       | 2,791                  |       | 4,426 |   |
|                                                                 |       |                   |       |   |   |
| NET INTEREST INCOME                                                  |       | 5,640                  |       | 4,696 |   |
|                                                                 |       |                   |       |   |   |
| PROVISION FOR LOAN LOSSES                                            |       | 53                     |       | 3,521 |   |
|                                                                 |       |                   |       |   |   |
| NET INTEREST INCOME AFTER PROVISION FOR LOAN  LOSSES                 |       | 5,587                  |       | 1,175 |   |
|                                                                 |       |                   |       |   |   |
| NONINTEREST INCOME:                                                  |       |                   |       |   |   |
| Deposit fee income                                                   |       | 1,190                  |       | 1,192 |   |
| Earnings on life insurance policies                                  |       | 198                    |       | 197 |   |
| Gain on sale of loans                                                |       | 136                    |       | 148 |   |
| Other                                                                |       | 297                    |       | 370 |   |
| Total noninterest income                                             |       | 1,821                  |       | 1,907 |   |
|                                                                 |       |                   |       |   |   |
| NONINTEREST EXPENSES:                                                |       |                   |       |   |   |
| Salaries and employee benefits                                       |       | 2,798                  |       | 2,967 |   |
| Occupancy expense                                                    |       | 670                    |       | 677 |   |
| Real estate owned, net                                               |       | 801                    |       | 395 |   |
| FDIC insurance premium                                               |       | 515                    |       | 241 |   |
| Data processing                                                      |       | 379                    |       | 408 |   |
| Professional fees                                                    |       | 406                    |       | 291 |   |
| Advertising and public relations                                     |       | 64                     |       | 111 |   |
| Postage and supplies                                                 |       | 161                    |       | 240 |   |
| Other                                                                |       | 808                    |       | 519 |   |
| Total noninterest expenses                                           |       | 6,602                  |       | 5,849 |   |
|                                                                 |       |                   |       |   |   |
| INCOME (LOSS) BEFORE INCOME TAXES                                    |       | 806                    |       | (2,767 | ) |
| INCOME TAX BENEFIT                                                   |       | (99                    | )          | (1,264 | ) |
| NET INCOME (LOSS)                                                    |       | 905                    |       | (1,503 | ) |
| PREFERRED STOCK DIVIDENDS AND ACCRETION OF  PREFERRED STOCK DISCOUNT |       | 222                    |       | 62 |   |
| NET INCOME (LOSS) AVAILABLE TO COMMON SHAREHOLDERS                   |       | $                      | 683        |   | $ | (1,565 | ) |
|                                                                 |       |                   |       |   |   |
| EARNINGS (LOSS) PER COMMON SHARE:                                    |       |                   |       |   |   |
| Basic                                                                |       | $                      | 0.14       |   | $ | (0.32 | ) |
|                                                                 |       |                   |       |   |   |
| Diluted                                                              |       | $                      | 0.14       |   | $ | (0.32 | ) |
|                                                                 |       |                   |       |   |   |
| Cash Dividends Declared                                              |       | $                      | —     |   | $ | 0.01 |   |

 

See notes to unaudited condensed consolidated financial statements.

 

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

**CONDENSEDCONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY**

**FOR THE THREE MONTHS ENDED MARCH 31, 2010**

(In thousands, except share data)

(Unaudited)

 
| ** **                             | ** ** | **Preferred Stock** | ** ** | **Common Stock** | ** ** | **Additional  Paid-In** | ** ** | **Retained  Earnings  (Substantially** | ** ** | **Treasury Stock** | ** ** | **Total Stockholders’** | ** ** |
|----------------------------------------|------------|---------------------|------------|------------------|------------|-------------------------|------------|----------------------------------------|------------|--------------------|------------|------------------------------|------------|
| ** **                             | ** ** | **Shares**          | ** ** | **Amount**       | ** ** | **Shares**              | ** ** | **Amount**                             | ** ** | **Capital**        | ** ** | **Restricted)**              | ** ** | **Shares** | ** ** | **Amount** | ** ** | **Equity** | ** ** |
|                                   |       |                |       |             |       |                    |       |                                   |       |               |       |                         |       |   |   |   |   |   |   |
| Balance, January 1,  2010         |       | 16,500              |       | $                | 16,195     |                    | 10,307,502 |                                   | $          | 103                |       | $                            | 56,986     |   | $ | 40,634 |   | 5,460,717 |   | $ | (70,618 | ) | $ | 43,300 |   |
| Net income                             |       |                |       |             |       |                    |       |                                   |       |               |       | 905                          |       |   |   |   |   | 905 |   |
| Preferred stock dividends              |       |                |       |             |       |                    |       |                                   |       |               |       | (206                         | )          |   |   |   |   | (206 | ) |
| Accretion of preferred  stock discount |       |                |       | 16               |       |                    |       |                                   |       |               |       | (16                          | )          |   |   |   |   | — |   |
|                                   |       |                |       |             |       |                    |       |                                   |       |               |       |                         |       |   |   |   |   |   |   |
| Balance, March 31,  2010          |       | 16,500              |       | $                | 16,211     |                    | 10,307,502 |                                   | $          | 103                |       | $                            | 56,986     |   | $ | 41,317 |   | 5,460,717 |   | $ | (70,618 | ) | $ | 43,999 |   |

 

See notes to unaudited condensed consolidated financial statements.

 

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

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

(In Thousands)

(Unaudited)

 
| ** **                                                                                | ** ** | **Three Months Ended March 31,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                | ** ** | **2010**                              | ** ** | **2009** | ** ** |
|                                                                                      |       |                                  |       |   |   |
| OPERATING ACTIVITIES:                                                                     |       |                                  |       |   |   |
| Net income (loss)                                                                         |       | $                                     | 905        |   | $ | (1,503 | ) |
| Adjustments to reconcile  net income (loss) to net cash provided by operating activities: |       |                                  |       |   |   |
| Provision for loan losses                                                                 |       | 53                                    |       | 3,521 |   |
| Provision for real estate  losses                                                         |       | 579                                   |       | 164 |   |
| Deferred tax provision  (benefit)                                                         |       | 153                                   |       | (1,919 | ) |
| Deferred tax asset  valuation allowance                                                   |       | (252                                  | )          | — |   |
| Accretion of discounts on  investment securities                                          |       | (16                                   | )          | (23 | ) |
| Federal Home Loan Bank  stock dividends                                                   |       | (3                                    | )          | (6 | ) |
| Loss (gain) on sale of  repossessed assets                                                |       | 51                                    |       | (22 | ) |
| Originations of loans held  for sale                                                      |       | (6,754                                | )          | (10,797 | ) |
| Proceeds from sales of  loans held for sale                                               |       | 7,507                                 |       | 11,310 |   |
| Gain on sale of loans  originated to sell                                                 |       | (136                                  | )          | (148 | ) |
| Depreciation                                                                              |       | 363                                   |       | 377 |   |
| Amortization of deferred  loan costs                                                      |       | 93                                    |       | 98 |   |
| Earnings on life insurance  policies                                                      |       | (198                                  | )          | (197 | ) |
| Changes in operating  assets and liabilities:                                             |       |                                  |       |   |   |
| Accrued interest  receivable                                                              |       | 557                                   |       | 1,675 |   |
| Prepaid expenses and other  assets                                                        |       | 274                                   |       | 68 |   |
| Other liabilities                                                                         |       | 383                                   |       | 564 |   |
| Net cash provided by  operating activities                                                |       | 3,559                                 |       | 3,162 |   |
|                                                                                      |       |                                  |       |   |   |
| INVESTING ACTIVITIES:                                                                     |       |                                  |       |   |   |
| Purchases of investment  securities held to maturity                                      |       | —                                |       | (68,571 | ) |
| Proceeds from  maturities/calls of investment securities held to maturity                 |       | 16,285                                |       | 69,591 |   |
| Federal Home Loan Bank  stock redeemed                                                    |       | 1,181                                 |       | 468 |   |
| Federal Home Loan Bank  Stock purchased                                                   |       | (475                                  | )          | — |   |
| Loan participations  purchased                                                            |       | (783                                  | )          | (485 | ) |
| Net loan repayments                                                                       |       | 21,243                                |       | 6,364 |   |
| Proceeds from sales of  repossessed assets                                                |       | 1,749                                 |       | 205 |   |
| Improvements to real  estate owned                                                        |       | (159                                  | )          | (12 | ) |
| Purchases of office  properties and equipment                                             |       | (32                                   | )          | (96 | ) |
| Net cash provided by  investing activities                                                |       | 39,009                                |       | 7,464 |   |
|                                                                                      |       |                                  |       |   |   |
| FINANCING ACTIVITIES:                                                                     |       |                                  |       |   |   |
| Net increase (decrease) in  deposits                                                      |       | (11,520                               | )          | 15,717 |   |
| Repayment of advances from  FHLB                                                          |       | (6,020                                | )          | (9,816 | ) |
| Short-term FHLB advances,  net                                                            |       | (18,000                               | )          | — |   |
| Net decrease in Federal  Reserve Bank advances                                            |       | —                                |       | (10,030 | ) |
| Net increase in advance  paymentsby borrowers for taxes and  insurance                    |       | 210                                   |       | 214 |   |
| Proceeds from issuance of  preferred stock and related common stock warrant               |       | —                                |       | 16,500 |   |
| Net cash provided by (used  in) financing activities                                      |       | (35,330                               | )          | 12,585 |   |
|                                                                                      |       |                                  |       |   |   |
| Net increase in cash and  cash equivalents                                                |       | 7,238                                 |       | 23,211 |   |
|                                                                                           |            |                                       |            |  |  |  |  |

 

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

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

(In Thousands)

(Unaudited)

 
| ** **                                                            | ** ** | **Three Months Ended March 31,** | ** ** |
|-----------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                            | ** ** | **2010**                              | ** ** | **2009** | ** ** |
| CASH AND CASH EQUIVALENTS:                                            |       |                                  |       |   |   |
| Beginning of period                                                   |       | $                                     | 22,149     |   | $ | 9,367 |   |
| End of period                                                         |       | $                                     | 29,387     |   | $ | 32,578 |   |
|                                                                  |       |                                  |       |   |   |
| SUPPLEMENTAL DISCLOSURES  OF CASH FLOW INFORMATION:                   |       |                                  |       |   |   |
| Cash paid for:                                                        |       |                                  |       |   |   |
| Interest                                                              |       | $                                     | 2,806      |   | $ | 4,480 |   |
| Income taxes                                                          |       | $                                     | —     |   | $ | 568 |   |
|                                                                  |       |                                  |       |   |   |
| SUPPLEMENTAL SCHEDULE OF  NONCASH INVESTING AND FINANCING ACTIVITIES: |       |                                  |       |   |   |
| Real estate and other  assets acquired in settlement of loans         |       | $                                     | 3,721      |   | $ | 5,425 |   |
| Loans to facilitate sales  of real estate owned                       |       | $                                     | 2,889      |   | $ | 2,346 |   |
| Investment securities  purchased — not settled                   |       | $                                     | —     |   | $ | 5,570 |   |
| Preferred stock dividends  accrued, not paid                          |       | $                                     | 206        |   | $ | — |   |

 
|   |   |   |   | (Concluded) |   |
|--------|--------|--------|--------|-------------|--------|

 

See notes to unauditedcondensed consolidated financial statements.

 

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

**NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

 

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

# ** **

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

 

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

 

The accompanying unaudited condensed consolidated financial statementsinclude the accounts of the Company and the Bank.  All material intercompany transactions havebeen eliminated in consolidation.

 

The results of operations for the threemonths ended March 31, 2010, are not necessarily indicative of the resultsto be expected for the year ending December 31, 2010.  The unaudited condensed consolidatedfinancial statements and notes thereto should be read in conjunction with theaudited financial statements and notes thereto for the year ended December 31,2009, contained in the Company’s 2009 Annual Report to Stockholders.

 

# **Note2 - Going Concern**

# ** **

The consolidated financial statements have been prepared on a goingconcern basis, which contemplates the realization of assets and thesatisfaction of liabilities in the normal course of business for theforeseeable future. However, the events and circumstances described belowcreate an uncertainty about the Company’s ability to continue as a goingconcern.  The unaudited condensedconsolidated financial statements do not include any adjustment that mightresult from the outcome of this uncertainty.

 

The Company recorded a net loss of $45.5 million in 2009, primarily dueto the level of nonperforming assets, the provision for loan losses of $44.4million, real estate owned expenses of $8.4 million, and FDIC insurancepremiums of $1.7 million.  Our losseswere largely a result of nonperforming loans and real estate owned. Our netloss also included the establishment of a valuation allowance against therealization of our deferred tax asset of $18.1 million.

 

At March 31, 2010, the Company was above the regulatory minimums fortangible, core, total risk-based and tier 1 risk-based capital.  On April 12, 2010, the Company and theBank each consented to the terms of Cease and Desist Orders issued by theOffice of Thrift Supervision (“OTS”) (the “Bank Order” and the “Company Order”and, together, the “Orders”).  The Ordersimpose certain operations restrictions on the Company and, to a greater extent,the Bank, including lending and dividend restrictions.  The Orders also require the Company and theBank to take certain actions, including the submission to the OTS of capitalplans and business plans to, among other things, preserve and enhance thecapital of the Company and the Bank and strengthen and improve the consolidatedCompany’s operations, earnings and profitability.  The Bank Order specifically requires the Bankto achieve and maintain, by December 31, 2010, a tier 1 (core) capitalratio of at least 8% and a total risk-based capital ratio of at least 12.0% andmaintain these higher ratios for as long as the Bank Order is in effect.  At March 31, 2010, the Bank’s core andtotal risk-based capital ratios were 6.17% and 10.64%.  Had the Bank been required to meet thesecapital requirements at March 31, 2010, it would have needed additionalcapital of approximately $12.8 million.

 

Management has developed and will continue to refine capital andstrategic plans which take into consideration available information in thedevelopment of future financial projections, which includes, but is not limitedto, twelve months from the balance sheet date of December 31, 2009. Theexpected results of these plans, forecasts and strategic initiatives, which arebased on multiple scenarios and stress tested cases, provide for theenhancement and preservation of capital. Management’s plans to preserve andenhance its capital levels depend on various factors, some of which are outsidethe control of management. These factors include improvement in the economy,the ability to raise capital, the ability to reduce nonperforming assets, andthe ability to maintain the Company’s liquidity.

 

The Company is continuing to aggressively pursue various availablealternatives to improve its capital ratios, including operating strategiesdesigned to increase profitability, through, among others, a reduction of nonperformingassets and reduction of operating costs, shrinking the balance sheet, andraising capital.  There can be noassurance that the economic conditions that caused the deterioration in loanquality, profits and capital will improve, and should the Bank’s capital andrelated ratios continue to deteriorate, the OTS could impose more severedirectives on the 

 

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Bank. The projected results of operations in 2010 and balance sheetshrinkage will not be sufficient to comply with the Orders.  Currently, the Company intends to raisecapital in the third or fourth quarter of 2010 to comply with the requirementsof the Orders.

 

The Company’s ability to raise additional capital will depend onconditions in the capital markets at that time, which are outside the Company’scontrol. Accordingly, the Company cannot be certain of its ability to raiseadditional capital on acceptable terms. The Company’s potential inability toraise capital and comply with the terms of the Order raises substantial doubtabout its ability to continue as a going concern.

 

**Note 3 – Recently AdoptedAccounting Standards**

 

OnJune 12, 2009, the Financial Accounting Standards Board (“FASB”) issuedASC 860, formerly FAS 166, *Accounting forTransfers of Financial Assets,*which**is arevision to ASC 860, formerly FAS 140, *Accountingfor Transfers and Servicing of Financial Assets and Extinguishments of Liabilities*,and requires more information about transfers of financial assets, includingsecuritization transactions, and where companies have continuing exposure tothe risks related to transferred financial assets. The statement alsoeliminates the concept of a “qualifying special-purpose entity”, changes therequirements for derecognizing financial assets and requires additionaldisclosures. It was effective for financial statements issued for interim andannual periods ending after November 15, 2009.  The recognition and measurement provisionsshall be applied to transfers that occur on or after the effective date. TheBank adopted this statement on January 1, 2010, as required.  The adoption of this statement did not have amaterial effect on the consolidated financial statements.

 

OnJune 12, 2009, the FASB issued ASC 860, formerly FAS 167, *Amendments to FASB Interpretation No. 46(R),*which changed the way entitiesaccount for securitizations and special-purpose entities. The statement is arevision to ASC 810, formerly FASB Interpretation No. 46(R), *Consolidation of Variable Interest Entities*,and changes how a company determines when an entity that is insufficientlycapitalized or is not controlled through voting (or similar rights) should beconsolidated. The determination of whether a company is required to consolidatean entity is based on, among other things, an entity’s purpose and design and acompany’s ability to direct the activities of the entity that mostsignificantly impact the entity’s economic performance. It was effective forfinancial statements issued for interim and annual periods ending after November 15,2009.  The Bank adopted this statement onJanuary 1, 2010, as required.  Theadoption of this statement did not have a material effect on the consolidatedfinancial statements.

 

InFebruary 2010, the FASB issued ASU No. 2010-09, *SubsequentEvents (Topic 855): Amendments to Certain Recognition and DisclosureRequirements*. The amendments remove the requirement for an SECregistrant to disclose the date through which subsequent events were evaluatedas this requirement would have potentially conflicted with SEC reportingrequirements. Removal of the disclosure requirement did not have an effect onthe nature or timing of subsequent events evaluations performed by the Company.ASU 2010-09 became effective upon issuance.

 

InJanuary 2010, the FASB issued ASU No. 2010-06, *Fair ValueMeasurements and Disclosures (Topic 820): Improving Disclosures about FairValue Measurements*. ASU 2010-06 revises two disclosure requirementsconcerning fair value measurements and clarifies two others. It requiresseparate presentation of significant transfers into and out of Levels 1 and 2of the fair value hierarchy and disclosure of the reasons for such transfers. Itwill also require the presentation of purchases, sales, issuances, andsettlements within Level 3 on a gross basis rather than a net basis. Theamendments also clarify that disclosures should be disaggregated by class ofasset or liability and that disclosures about inputs and valuation techniquesshould be provided for both recurring and non-recurring fair valuemeasurements. The Company’s disclosures about fair value measurements arepresented in Note 10. These new disclosure requirements were effective for theperiod ended March 31, 2010, except for the requirement concerning grosspresentation of Level 3 activity, which is effective for fiscal years beginningafter December 15, 2010. There was no significant effect on the Company’sfinancial statement disclosure upon adoption of this ASU.

 

**Note 4 – Preferred Stock**

** **

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

 

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theWarrant associated with such preferred shares. The Warrant has a 10-year term and was immediately exercisable upon itsissuance, with an exercise price, subject to anti-dilution adjustments, equalto $7.69 per share of the Common Stock.  Treasury has agreed not to exercise voting power with respect to anyshares of Common Stock issued upon exercise of the Warrant that it holds.

 

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

 

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

 

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

 

TheCompany and the Bank are subject to a regulatory order which prohibits theCompany and the Bank from paying dividends on any of its stock, including the Series APreferred Stock, without prior written non-objection of the OTS.  As a result, the Company elected to deferpayment of its Series A Preferred Stock dividends beginning with thedividend payment that was due February 15, 2010.  However, the Company will continue to accruethese dividends and at March 31, 2010 dividends of approximately $312,000were accrued in other liabilities on the consolidated statement of financialcondition related to these dividend payments.

 

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**Note 5 - Earnings per CommonShare**

 

The weighted average number of common shares used to calculate earningsper share for the periods ended March 31, 2010 and 2009 were as follows:

 
| ** **                               | ** ** | **Three months ended  March 31,** | ** ** |
|------------------------------------------|------------|----------------------------------------|------------|
| ** **                               | ** ** | **2010**                               | ** ** | **2009** | ** ** |
| Basic weighted - average common shares   |       | 4,846,785                              |       | 4,848,785 |   |
| Effect of dilutive securities            |       | —                                 |       | — |   |
| Diluted weighted - average common shares |       | 4,846,785                              |       | 4,848,785 |   |

 

The calculation of dilutedearnings per share excludes 15,482 and 17,242 options outstanding for the threemonths ended March 31, 2010 and 2009, respectively, which were antidilutive. Inaddition, the calculation excludes the Warrant to purchase 321,847 shares ofcommon stock outstanding for the three month periods ended March 31, 2010 and2009, which was antidilutive.

 

**Note 6 — Investment Securities**

 

Investmentsecurities consisted of the following (in thousands):

 
| ** **                             | ** ** | **March 31, 2010** | ** ** |
|----------------------------------------|------------|--------------------|------------|
| ** **                             | ** ** | ** **         | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                             | ** ** | **Amortized**      | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| **Held To Maturity**                   | ** ** | **Cost**           | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
|                                   |       |               |       |   |   |   |   |   |   |
| Municipal securities                   |       | $                  | 24,846     |   | $ | 236 |   | $ | (232 | ) | $ | 24,850 |   |
| U.S. Government and Agency obligations |       | 94,416             |       | 218 |   | (786 | ) | 93,848 |   |
|                                   |       |               |       |   |   |   |   |   |   |
| Total                                  |       | $                  | 119,262    |   | $ | 454 |   | $ | (1,018 | ) | $ | 118,698 |   |

 
| ** **                             | ** ** | **December 31, 2009** | ** ** |
|----------------------------------------|------------|----------------------------|------------|
| ** **                             | ** ** | ** **                 | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                             | ** ** | **Amortized**              | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| **Held To Maturity**                   | ** ** | **Cost**                   | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
|                                   |       |                       |       |   |   |   |   |   |   |
| Municipal securities                   |       | $                          | 25,480     |   | $ | 247 |   | $ | (269 | ) | $ | 25,458 |   |
| U.S. Government and Agency obligations |       | 110,051                    |       | 21 |   | (3,021 | ) | 107,051 |   |
|                                   |       |                       |       |   |   |   |   |   |   |
| Total                                  |       | $                          | 135,531    |   | $ | 268 |   | $ | (3,290 | ) | $ | 132,509 |   |

 

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Thefollowing tables summarize the gross unrealized losses and fair value of theCompany’s investments with unrealized losses that are not deemed to beother-than-temporarily impaired (“OTTI”) (in thousands), aggregated byinvestment category and length of time that individual securities have been ina continuous unrealized loss position:

 
| ** **                             | ** ** | **March 31, 2010** | ** ** |
|----------------------------------------|------------|-------------------------|------------|
| ** **                             | ** ** | **Less than 12 Months** | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
| ** **                             | ** ** | **Fair**                | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                             | ** ** | **Value**               | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** |
|                                   |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Municipal securities                   |       | $                       | 3,750      |   | $ | 77 |   | $ | 2,476 |   | $ | 155 |   | $ | 6,226 |   | $ | 232 |   |
| U.S. Government and Agency obligations |       | 30,387                  |       | 236 |   | 19,186 |   | 550 |   | 49,573 |   | 786 |   |
|                                   |       |                    |       |   |   |   |   |   |   |   |   |   |   |
|                                   |       | $                       | 34,137     |   | $ | 313 |   | $ | 21,662 |   | $ | 705 |   | $ | 55,799 |   | $ | 1,018 |   |

 
| ** **                             | ** ** | **December 31, 2009** | ** ** |
|----------------------------------------|------------|----------------------------|------------|
| ** **                             | ** ** | **Less than 12 Months**    | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
| ** **                             | ** ** | **Fair**                   | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                             | ** ** | **Value**                  | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** |
|                                   |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Municipal securities                   |       | $                          | 5,156      |   | $ | 92 |   | $ | 2,453 |   | $ | 177 |   | $ | 7,609 |   | $ | 269 |   |
| U.S. Government and Agency obligations |       | 100,142                    |       | 2,908 |   | 2,888 |   | 113 |   | 103,030 |   | 3,021 |   |
|                                   |       |                       |       |   |   |   |   |   |   |   |   |   |   |
|                                   |       | $                          | 105,298    |   | $ | 3,000 |   | $ | 5,341 |   | $ | 290 |   | $ | 110,639 |   | $ | 3,290 |   |

 

Ona quarterly basis, management conducts a formal review of securities for thepresence of OTTI.  Management assesses whether an OTTI is presentwhen the fair value of a security is less than its amortized cost basis at thebalance sheet date.  For such securities, OTTI is considered to haveoccurred if the Company intends to sell the security, if it is more likely thannot the Company will be required to sell the security before recovery of itsamortized cost basis or if the present values of expected cash flows is notsufficient to recover the entire amortized cost.

 

Theunrealized losses are primarily a result of increases in market yields from thetime of purchase.  In general, as market yields rise, the fair valueof securities will decrease; as market yields fall, the fair value ofsecurities will increase. Management generally views changes in fair value causedby changes in interest rates as temporary; therefore, these securities have notbeen classified as other-than-temporarily impaired.  Additionally,the unrealized losses are also considered temporary because scheduled couponpayments have been made, it is anticipated that the entire principal balancewill be collected as scheduled, and management neither intends to sell thesecurities nor is it more likely than not that the Company will be required tosell the securities before the recovery of the remaining amortized cost amount.

 

TheCompany has pledged investment securities held to maturity with carrying valuesof approximately $42.8 million at March 31, 2010, and $59.5 million at December 31,2009 as collateral for certain deposits in excess of $250,000.

 

Thescheduled maturities of debt securities at March 31, 2010, by contractualmaturity are shown below (in thousands). Expected maturities may differ fromcontractual maturities because borrowers may have the right to call or prepayobligations with or without call or prepayment penalties.

 
| ** **                       | ** ** | **March 31, 2010** | ** ** |
|----------------------------------|------------|-------------------------|------------|
| ** **                       | ** ** | **Amortized**           | ** ** | **Fair** | ** ** |
| ** **                       | ** ** | **Cost**                | ** ** | **Value** | ** ** |
|                             |       |                    |       |   |   |
| Within one year                  |       | $                       | 200        |   | $ | 203 |   |
| Due from one year to five years  |       | 3,345                   |       | 3,341 |   |
| Due from five years to ten years |       | 7,195                   |       | 7,147 |   |
| Due after ten years              |       | 108,522                 |       | 108,007 |   |
|                             |       |                    |       |   |   |
| Total                            |       | $                       | 119,262    |   | $ | 118,698 |   |

 

Asof March 31, 2010 and December 31, 2009, investments with carryingvalues of approximately $112.4 million and $127.6 million, respectively, havecall options held by the issuer, of which approximately $89.4 million and $99.2million, respectively, are or were callable within one year.

 

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**Note 7 — Impaired Loans**

 

Impairedloans consisted of the following as of the dates indicated (in thousands):

 
| ** **                                      | ** ** | **March 31,  2010** | ** ** | **December 31,  2009 (1)** | ** ** |
|-------------------------------------------------|------------|--------------------------|------------|---------------------------------|------------|
| ** **                                      | ** ** | **Recorded  Investment** | ** ** | **Valuation  Allowance**        | ** ** | **Carrying  Value** | ** ** | **Recorded  Investment** | ** ** | **Valuation  Allowance** | ** ** | **Carrying  Value** | ** ** |
| Nonaccrual loans with a  valuation allowance    |       | $                        | 33,586     |                            | $          | 8,638 |   | $ | 24,948 |   | $ | 24,095 |   | $ | 7,476 |   | $ | 16,619 |   |
| Nonaccrual loans  without a valuation allowance |       | 21,605                   |       | —                          |       | 21,605 |   | 26,248 |   | — |   | 26,248 |   |
| Total nonaccrual loans                          |       | 55,191                   |       | 8,638                           |       | 46,553 |   | 50,343 |   | 7,476 |   | 42,867 |   |
| Performing restructured  loans (2)              |       | 4,846                    |       | —                          |       | 4,846 |   | 4,609 |   | — |   | 4,609 |   |
| Other impaired loans  (3)                       |       | 10,581                   |       | —                          |       | 10,581 |   | 6,334 |   | — |   | 6,334 |   |
| Total impaired loans                            |       | $                        | 70,618     |                            | $          | 8,638 |   | $ | 61,980 |   | $ | 61,286 |   | $ | 7,476 |   | $ | 53,810 |   |

 
|                                          |   |   |   |   |   | **Three Months Ended  March 31, 2010** |   |   |   |   |   | **Year Ended  December 31, 2009** |   |
|-----------------------------------------------|--------|--------|--------|--------|--------|---------------------------------------------|--------|--------|--------|--------|--------|----------------------------------------|--------|
| Average investment in  impaired loans         |   |   |   |   |   | $                                           | 57,848 |   |   |   |   |                                   | $      | 48,609 |   |
|                                          |   |   |   |   |   |                                        |   |   |   |   |   |                                   |   |
| Interest income  recognized on impaired loans |   |   |   |   |   | $                                           | 415    |   |   |   |   |                                   | $      | 1,747 |   |
|                                          |   |   |   |   |   |                                        |   |   |   |   |   |                                   |   |
| Interest based on  original terms             |   |   |   |   |   | $                                           | 1,182  |   |   |   |   |                                   | $      | 4,355 |   |

 

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(1)          Subsequent to the issuance ofthe Company’s 2009 consolidated financial statements included in its AnnualReport on Form 10-K, filed on April 15, 2010, management identifiedan immaterial error in the disclosure of impaired loans in the tableabove.  Impaired loans of $20.5 million were omitted from the previouslypresented disclosure as of December 31, 2009.  This amount primarilyrepresents impaired non-homogeneous loans less than $500,000 and borrowerrelationships less than $1.0 million.  The disclosed amounts ofimpaired loans without valuation allowance and impaired loans with a valuationallowance previously presented have been restated to include these impairedloans and restated to conform with the current presentation.  Thepreviously omitted loans did not impact the consolidated statements offinancial condition, operations or cash flows for the year ended December 31,2009.

(2)          Performingrestructured loans represent (1) loans that were not already on nonaccrualstatus before the restructuring that have been restructured so as to bereasonably assured of repayment and of performance according to prudentmodified terms or (2) loans that have had sustained historical repaymentperformance for a reasonable period of time after the restructuring, generallya minimum of six months.  After arestructured loan has performed satisfactorily for a period of at least 12months, it is generally no longer reported as a restructured loan for financialreporting purposes.

(3)          Other impaired loansgenerally include loans for which there may be doubt about the ultimate timingof collection of principal and interest compared to the original terms of thenote but where the payment history has been satisfactory and collateralcoverage is estimated to be adequate to pay principal and interest infull.  Total accrued interest for theseloans was $110,000 at March 31, 2010, and $52,000 at December 31,2009.  At March 31, 2010, otherimpaired loans included three loans totaling $3.0 million with accrued interestof $22,000 that were 30-59 days past due and one loan of $234,000 with accruedinterest of $5,000 that was 60-89 days past due.

 

**Note 8 — Allowances for Loan andReal Estate Losses**

 

Asummary of the activity in the allowances for loan and real estate losses is asfollows for the three months ended March 31 (in thousands):

 
| ** **                        | ** ** | **Three Months Ended  March 31, 2010** | ** ** | **Three Months Ended  March 31, 2009** | ** ** |
|-----------------------------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|
| ** **                        | ** ** | **Loans**                                   | ** ** | **Real Estate**                             | ** ** | **Loans** | ** ** | **Real Estate** | ** ** |
|                              |       |                                        |       |                                        |       |   |   |   |   |
| Balance—beginning  of period |       | $                                           | 32,908     |                                        | $          | 5,543 |   | $ | 6,441 |   | $ | — |   |
|                              |       |                                        |       |                                        |       |   |   |   |   |
| Provisions  for estimated losses  |       | 53                                          |       | 579                                         |       | 3,521 |   | 164 |   |
| Recoveries                        |       | 70                                          |       | —                                      |       | 60 |   | — |   |
| Losses  charged off               |       | (379                                        | )          | (199                                        | )          | (464 | ) | (164 | ) |
|                              |       |                                        |       |                                        |       |   |   |   |   |
| Balance—end  of period       |       | $                                           | 32,652     |                                        | $          | 5,923 |   | $ | 9,558 |   | $ | — |   |

 

Theallowance for loan losses as of March 31, 2010 and 2009 includes generalvaluation allowances of $24.0 million and $4.7 million, respectively, andspecific valuation allowances of $8.6 million and $4.9 million,respectively.  The provision for loanlosses decreased between the periods listed above primarily due to decreases inloan balances offset by increases in total nonaccrual loans and in the lossfactors used in certain allowance categories, as well as an increase inspecific loan loss allowances, in each respect due to deteriorating economicconditions.

 

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**Note 9 — Income Taxes**

 

Theprovisions (benefits) for income taxes are summarized as follows (in thousands):

 
| ** **                      | ** ** | **Three Months Ended**  | ** ** |
|---------------------------------|------------|-------------------------|------------|
| ** **                      | ** ** | **March 31, 2010** | ** ** | **March 31, 2009** | ** ** |
|                            |       |                    |       |   |   |
| Income tax provision (benefit): |       |                    |       |   |   |
| Current:                        |       |                    |       |   |   |
| Federal                         |       | $                       | —     |   | $ | 645 |   |
| State                           |       | —                  |       | 10 |   |
| Total current                   |       | —                  |       | 655 |   |
|                            |       |                    |       |   |   |
| Deferred:                       |       |                    |       |   |   |
| Federal                         |       | 101                     |       | (1,615 | ) |
| State                           |       | 52                      |       | (304 | ) |
| Valuation allowance             |       | (252                    | )          | — |   |
| Total deferred                  |       | (99                     | )          | (1,919 | ) |
|                            |       |                    |       |   |   |
| Total                           |       | $                       | (99        | ) | $ | (1,264 | ) |

 

Thereasons for the differences between the statutory federal income tax rates andthe effective tax rates are summarized as follows (in thousands):

 
| ** **                          | ** ** | **Three Months Ended March 31,** | ** ** |
|-------------------------------------|------------|---------------------------------------|------------|
| ** **                          | ** ** | **2010**                              | ** ** | **2009** | ** ** |
|                                |       |                                  |       |   |   |   |   |   |   |
| Taxes at statutory rate             |       | $                                     | 274        |   | 34.0 | % | $ | (941 | ) | 34.0 | % |
| Increase (decrease) resulting from: |       |                                  |       |   |   |   |   |   |   |
| State income tax—net           |       | 35                                    |       | 4.3 |   | (168 | ) | 6.1 |   |
| Valuation allowance                 |       | (252                                  | )          | (31.3 | ) | — |   | — |   |
| Earnings on life insurance policies |       | (67                                   | )          | (8.3 | ) | (67 | ) | 2.4 |   |
| Nontaxable investments              |       | (89                                   | )          | (11.0 | ) | (67 | ) | 2.4 |   |
| Other—net                      |       | —                                |       | — |   | (21 | ) | 0.8 |   |
|                                |       |                                  |       |   |   |   |   |   |   |
| Total                               |       | $                                     | (99        | ) | (12.3 | )% | $ | (1,264 | ) | 45.7 | % |

 

TheCompany’s net deferred tax liability account was comprised of the following (inthousands):

 
| ** **                                     | ** ** | **March 31, 2010** | ** ** | **December 31, 2009** | ** ** |
|------------------------------------------------|------------|-------------------------|------------|----------------------------|------------|
|                                           |       |                    |       |                       |       |
| Deferred tax assets:                           |       |                    |       |                       |       |
| Allowance for loan losses                      |       | $                       | 10,233     |                       | $          | 11,054 |   |
| Real estate owned                              |       | 3,621                   |       | 3,426                      |       |
| NOL carryovers                                 |       | 4,790                   |       | 4,432                      |       |
| Other                                          |       | 190                     |       | 190                        |       |
| Total deferred tax assets                      |       | 18,834                  |       | 19,102                     |       |
| Valuation allowance                            |       | (17,872                 | )          | (18,124                    | )          |
| Deferred tax asset, net of valuation allowance |       | 962                     |       | 978                        |       |
|                                           |       |                    |       |                       |       |
| Deferred tax liabilities:                      |       |                    |       |                       |       |
| Office properties                              |       | (903                    | )          | (928                       | )          |
| Federal Home Loan Bank stock                   |       | (202                    | )          | (300                       | )          |
| Pension plan contribution                      |       | (47                     | )          | (94                        | )          |
| Prepaid expenses                               |       | (185                    | )          | (130                       | )          |
| Total deferred tax liabilities                 |       | (1,337                  | )          | (1,452                     | )          |
|                                           |       |                    |       |                       |       |
| Deferred tax liability, net                    |       | $                       | (375       | )                          | $          | (474 | ) |

 

Adeferred tax asset or liability is recognized for the tax consequences oftemporary differences in the recognition of revenue and expense, and unrealizedgains and losses, for financial and tax reporting purposes. Deferred tax assetsare reduced by a valuation allowance when, in the opinion of management, it ismore likely than not that some or all of the deferred tax assets will notbe realized. The Company conducted an analysis to assess the need for a 

 

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valuationallowance at March 31, 2010. As part of this assessment, all availableevidence, including both positive and negative, was considered to determinewhether, based on the weight of such evidence, a valuation allowance on theCompany’s deferred tax assets was needed. In accordance with ASC Topic 740-10,Income Taxes (ASC 740), a valuation allowance is deemed to be needed when,based on the weight of the available evidence, it is more likely than not (alikelihood of more than 50%) that some portion or all of a deferred tax assetwill not be realized. The future realization of the deferred tax asset dependson the existence of sufficient taxable income within the carryback andcarryforward periods.  The carryback andcarryforward periods for federal tax are two years and twenty years,respectively.  The state tax carryforwardperiod is five years with no carryback period allowed.

 

Aspart of its analysis, the Company considered the following positive evidence:

 

·                  The Company hasa long history of earnings profitability.

·                  The Company isprojecting future taxable income sufficient to utilize all net operatingloss carryforwards prior to expiration.

·                  Future reversalsof certain deferred tax liabilities.

·                  The FederalReserve has indicated that the economy has exited the recession.

 

Aspart of its analysis, the Company considered the following negative evidence:

 

·                  The Companyrecorded a large net loss in 2009.

·                  The Company didnot meet its financial goals in 2009.

·                  The Company maynot meet its projections concerning future taxable income.

 

AtMarch 31, 2010, we determined that a valuation allowance relating to boththe federal and state portion of our deferred tax asset was necessary. Thisdetermination for the state deferred tax asset was based largely on the negativeevidence represented by the level of state tax exempt interest income whichreduces state taxable income to a level that makes it unlikely the Company willrealize its state deferred tax asset. Therefore, valuation allowances of $14.5million and $3.4 million at March 31, 2010 were recorded for a portion ofthe federal deferred tax asset and all of the state deferred tax asset,respectively.

 

Specificallyexempted from deferred tax recognition requirements are bad debt reserves fortax purposes of U.S. savings and loans in the institution’s base year, asdefined. Base year reserves totaled approximately $4.2 million. Consequently, adeferred tax liability of approximately $1.6 million related to such reserveswas not provided for in the consolidated statements of financial condition at March 31,2010 and December 31, 2009. Payment of dividends to shareholders out ofretained earnings deemed to have been made out of earnings previously set asideas bad debt reserves may create taxable income to the Bank. No provision hasbeen made for income tax on such a distribution as the Bank does not anticipatemaking such distributions.

 

TheCompany files income tax returns in the U.S. federal jurisdiction and the stateof Arkansas. The Company is subject to U.S. federal and state income taxexaminations by tax authorities for tax years ended December 31, 2007 andforward.  The Company’s 2007 federalincome tax return was subject to a limited scope examination by the InternalRevenue Service during the first quarter of 2009.  As a result of the examination, the Companywas assessed approximately $45,000, including interest, for the 2007 taxyear.  The Company recognizes interestand penalties on income taxes as a component of income tax expense.

 

**Note 10— Fair Value Measurement**

 

ASC820, formerly SFAS 157, *Fair Value Measurement*,provides a framework for measuring fair value and defines fair value as theexchange price that would be received for an asset or paid to transfer aliability (an exit price) in the principal or most advantageous market for theasset or liability in an orderly transaction between market participants on themeasurement date. ASC 820 also establishes a fair value hierarchy whichrequires an entity to maximize the use of observable inputs and minimize theuse of unobservable inputs when measuring fair value. ASC 820 describes threelevels of inputs that 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.                                                                                                                                                                 |

 

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Thefollowing is a description of valuation methodologies used for significantassets measured at fair value on a non-recurring basis.

 

*Loans Receivable*

Loanswhich meet certain criteria are evaluated individually for impairment. A loanis considered impaired when, based upon current information and events, it isprobable the Bank will be unable to collect all amounts due, includingprincipal and interest, according to the contractual terms of the loanagreement.  Substantially all of the Bank’s impaired loans at March 31,2010 are secured by real estate.  These impaired loans areindividually assessed to determine that the carrying value of the loan is notin excess of the fair value of the collateral, less estimated selling costs.Fair value is estimated through current appraisals, real estate brokers orlisting prices.  Fair values may be adjusted by management to reflectcurrent economic and market conditions and, as such, are classified asLevel 3.  Impaired loans recorded at fair value with partialcharge-offs and specific valuation allowances were $35.7 million net ofspecific valuation allowances of $8.6 million at March 31, 2010.

 

*Real Estate Owned, net (“REO”)*

REOrepresents real estate acquired as a result of foreclosure or by deed in lieuof foreclosure and is carried at the lower of cost or fair value less estimatedselling costs.  Fair value is estimated through current appraisals,real estate brokers or listing prices.  As these properties areactively marketed, estimated fair values may be adjusted by management toreflect current economic and market conditions and, as such, are classified asLevel 3.  REO at March 31, 2010 was $33.6 million. During the threemonths ended March 31, 2010, charge-offs to the allowance for loan lossesrelated to loans that were transferred to REO were $153,000 ontransfers to REO of $3.7 million.  Writedowns related to REO that were charged to expense were $579,000 for the threemonths ended March 31, 2010.

 

Thefollowing table provides the level of valuation assumption used to determinethe carrying value of the Company’s assets measured at fair value on anon-recurring basis at March 31, 2010:

 
| ** **     | ** ** | **Fair Value** | ** ** | **Quoted Prices in  Active Markets for  Identical Assets  (Level 1)** | ** ** | **Significant********Other Observable  Inputs********(Level 2)** | ** ** | **Significant********Unobservable********Inputs********(Level 3)** | ** ** |
|----------------|------------|----------------|------------|-----------------------------------------------------------------------|------------|------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| Impaired loans |       | $              | 35,717     |                                                                  | $          | —                                                           |       | $                                                                  | —     |   | $ | 35,717 |   |
| REO, net (1)   |       | 34,549         |       | —                                                                |       | —                                                           |       | 34,549                                                             |       |
|           |       | $              | 70,266     |                                                                  | $          | —                                                           |       | $                                                                  | —     |   | $ | 70,266 |   |

 

----

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

 

**FAIRVALUE OF FINANCIAL INSTRUMENTS**

 

Theestimated fair value amounts have been determined by the Company usingavailable market information and appropriate valuation methodologies. However,considerable judgment is required to interpret market data to develop theestimates of fair value. Accordingly, the estimates presented herein are notnecessarily indicative of the amounts the Company could realize in a currentmarket exchange. The use of different market assumptions and/or estimationmethodologies may have a material effect on the estimated fair value amounts.The estimated fair values of financial instruments are as follows (in thousands):

 
| ** **                                             | ** ** | **March 31,  2010** | ** ** | **December 31,  2009** | ** ** |
|--------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                                             | ** ** | ** **               | ** ** | **Estimated**               | ** ** | ** ** | ** ** | **Estimated** | ** ** |
| ** **                                             | ** ** | **Carrying**             | ** ** | **Fair**                    | ** ** | **Carrying** | ** ** | **Fair** | ** ** |
| ** **                                             | ** ** | **Value**                | ** ** | **Value**                   | ** ** | **Value** | ** ** | **Value** | ** ** |
| ASSETS:                                                |       |                     |       |                        |       |   |   |   |   |
| Cash and cash equivalents                              |       | $                        | 29,387     |                        | $          | 29,387 |   | $ | 22,149 |   | $ | 22,149 |   |
| Investment securities—held to maturity            |       | 119,262                  |       | 118,698                     |       | 135,531 |   | 132,509 |   |
| Federal Home Loan Bank stock                           |       | 2,422                    |       | 2,422                       |       | 3,125 |   | 3,125 |   |
| Loans receivable—net                              |       | 460,104                  |       | 463,834                     |       | 481,542 |   | 483,127 |   |
| Loans held for sale                                    |       | 395                      |       | 395                         |       | 1,012 |   | 1,012 |   |
| Cash surrender value of life insurance                 |       | 21,424                   |       | 21,424                      |       | 21,226 |   | 21,226 |   |
| Accrued interest receivable                            |       | 3,672                    |       | 3,672                       |       | 4,229 |   | 4,229 |   |
|                                                   |       |                     |       |                        |       |   |   |   |   |
| LIABILITIES:                                           |       |                     |       |                        |       |   |   |   |   |
| Deposits:                                              |       |                     |       |                        |       |   |   |   |   |
| Checking, money market and savings accounts            |       | 213,355                  |       | 213,355                     |       | 245,287 |   | 245,287 |   |
| Certificates of deposit                                |       | 399,749                  |       | 401,670                     |       | 379,337 |   | 383,187 |   |
| Other borrowings                                       |       | 35,526                   |       | 36,107                      |       | 59,546 |   | 60,203 |   |
| Accrued interest payable                               |       | 459                      |       | 459                         |       | 474 |   | 474 |   |
| Advance payments by borrowers for taxes and  insurance |       | 905                      |       | 905                         |       | 695 |   | 695 |   |
|                                                        |            |                          |            |                             |            |  |  |  |  |  |  |  |  |

 

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Forcash and cash equivalents, Federal Home Loan Bank stock, cash surrender valueof life insurance and accrued interest receivable, the carrying value is a reasonableestimate of fair value, primarily because of the short-term nature of theinstruments or, as to Federal Home Loan Bank stock, the ability to sell thestock back to the Federal Home Loan Bank at cost. The fair value of investmentsecurities is based on quoted market prices, dealer quotes and prices obtainedfrom independent pricing services. The fair value of variable rate loans isbased on repricing dates. Fixed rate loans were valued using discounted cashflows. The discount rates used to determine the present value of these loanswere based on interest rates currently being charged by the Bank on comparableloans as to credit risk and term.

 

Thefair value of checking accounts, savings accounts and money market deposits isthe amount payable on demand at the reporting date. The fair value offixed-maturity certificates of deposit and Federal Home Loan Bank advances isestimated using the rates currently offered for deposits of similar terms andadvances of similar remaining maturities at the reporting date. For advancepayments by borrowers, for taxes and insurance, accrued interest payable andFederal Reserve Bank advances, the carrying value is a reasonable estimate offair value, primarily because of the short-term nature of the instruments.

 

Thefair value estimates presented herein are based on pertinent informationavailable to management as of March 31, 2010 and December 31, 2009.Although management is not aware of any factors that would significantly affectthe estimated fair value amounts, such amounts have not been comprehensivelyrevalued for purposes of these financial statements since the reporting dateand, therefore, current estimates of fair value may differ significantly fromthe amounts presented herein.

 

**Note 11 — Regulatory Matters**

 

TheBank is subject to various regulatory capital requirements administered by theOTS. Failure to meet minimum capital requirements can initiate certainmandatory—and possible additional discretionary—actions by regulators that, ifundertaken, could have a direct and material effect on the Bank’s financialstatements. Under capital adequacy guidelines and the regulatory framework forprompt corrective action, the Bank must meet specific capital guidelines thatinvolve quantitative measures of the Bank’s assets, liabilities, and certainoff-balance sheet items as calculated under regulatory accounting practices.The Bank’s capital amounts and classification are also subject to qualitativejudgments by the regulators about components, risk weightings, and otherfactors.

 

Quantitativemeasures established by regulation to ensure capital adequacy require the Bankto maintain minimum amounts and ratios (set forth in the following table) oftangible capital (as defined) to tangible assets (as defined) and core capital(as defined) to adjusted tangible assets (as defined), and of total risk-basedcapital (as defined) to risk-weighted assets (as defined).   Tier 1 (core) capital includes commonstockholders’ equity and qualifying preferred stock less certain otherdeductions.  Total capital includes tier1 capital plus the allowance for loan losses, subject to limitations.

 

Asthe following table indicates, at March 31, 2010, the Bank was above theregulatory adequacy minimums for tangible, core, total risk-based and tier 1risk-based capital.  At December 31,2009, the Bank was below the regulatory adequacy minimum for total risk-basedcapital and above the regulatory adequacy minimums for tangible, core, and tier1 risk-based capital. The Bank had historically been categorized aswell-capitalized in periods prior to December 31, 2009.

 

TheBank’s actual capital amounts (in thousands) and ratios are presented in thefollowing table:

 
| ** **                               | ** ** | ** ** | ** ** | ** **            | ** ** | ** **            | ** ** | ** **            | ** ** | **To be Categorized** | ** ** |
|------------------------------------------|------------|------------|------------|-----------------------|------------|-----------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                               | ** ** | ** ** | ** ** | ** **            | ** ** | ** **            | ** ** | ** **            | ** ** | **as Adequately**     | ** ** |
| ** **                               | ** ** | ** ** | ** ** | ** **            | ** ** | ** **            | ** ** | ** **            | ** ** | **Capitalized Under** | ** ** |
| ** **                               | ** ** | ** ** | ** ** | ** **            | ** ** | **For Capital**       | ** ** | **Prompt Corrective** | ** ** |
| ** **                               | ** ** | **Actual** | ** ** | **Adequacy Purposes** | ** ** | **Action Provisions** | ** ** |
| ** **                               | ** ** | **Amount** | ** ** | **Ratio**             | ** ** | **Amount**            | ** ** | **Ratio**             | ** ** | **Amount**            | ** ** | **Ratio** | ** ** |
|                                     |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| As of March 31, 2010:               |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
|                                     |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| Tangible Capital to Tangible Assets      |       | $          | 43,030     |                  | 6.17       | %                     | $          | 10,459                |       | 1.50                  | %          | N/A |   | N/A |   |
|                                     |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| Core Capital to Adjusted Tangible Assets |       | 43,030     |       | 6.17                  | %          | 34,862                |       | 5.00                  | %          | $                     | 34,862     |   | 5.00 | % |
|                                     |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| Total Capital to Risk-Weighted Assets    |       | 49,014     |       | 10.64                 | %          | 46,077                |       | 10.00                 | %          | 46,077                |       | 10.00 | % |
|                                     |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| Tier I Capital to Risk-Weighted Assets   |       | 43,030     |       | 9.34                  | %          | N/A                   |       | N/A                   |       | 18,431                |       | 4.00 | % |
|                                          |            |            |            |                       |            |                       |            |                       |            |                       |            |  |  |  |  |  |

 

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| ** **                               | ** ** | ** ** | ** ** | ** **            | ** ** | ** **            | ** ** | ** **            | ** ** | **To be Categorized** | ** ** |
|------------------------------------------|------------|------------|------------|-----------------------|------------|-----------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                               | ** ** | ** ** | ** ** | ** **            | ** ** | ** **            | ** ** | ** **            | ** ** | **as Adequately**     | ** ** |
| ** **                               | ** ** | ** ** | ** ** | ** **            | ** ** | ** **            | ** ** | ** **            | ** ** | **Capitalized Under** | ** ** |
| ** **                               | ** ** | ** ** | ** ** | ** **            | ** ** | **For Capital**       | ** ** | **Prompt Corrective** | ** ** |
| ** **                               | ** ** | **Actual** | ** ** | **Adequacy Purposes** | ** ** | **Action Provisions** | ** ** |
| ** **                               | ** ** | **Amount** | ** ** | **Ratio**             | ** ** | **Amount**            | ** ** | **Ratio**             | ** ** | **Amount**            | ** ** | **Ratio** | ** ** |
|                                     |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| As of December 31, 2009:            |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
|                                     |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| Tangible Capital to Tangible Assets      |       | $          | 42,042     |                  | 5.75       | %                     | $          | 10,965                |       | 1.50                  | %          | N/A |   | N/A |   |
|                                     |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| Core Capital to Adjusted Tangible Assets |       | 42,042     |       | 5.75                  | %          | 36,550                |       | 5.00                  | %          | $                     | 36,550     |   | 5.00 | % |
|                                     |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| Total Capital to Risk-Weighted Assets    |       | 48,344     |       | 9.97                  | %          | 48,512                |       | 10.00                 | %          | 48,512                |       | 10.00 | % |
|                                     |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| Tier I Capital to Risk-Weighted Assets   |       | 42,042     |       | 8.67                  | %          | N/A                   |       | N/A                   |       | 19,405                |       | 4.00 | % |
|                                          |            |            |            |                       |            |                       |            |                       |            |                       |            |  |  |  |  |  |

 

Asdiscussed further in Part I, Item 2 under the section “Executive Summary —Regulatory Enforcement Actions”, on April 12, 2010, the Company and theBank each consented to the terms of Cease and Desist Orders issued by the OTS.The Orders became effective on April 14, 2010. The Bank Order states thatno later than December 31, 2010, the Bank shall achieve and maintain aTier 1 (Core) capital ratio of at least 8% and a total risk-based capital ratioof at least 12%.  The Bank had previouslyagreed with the OTS to maintain a corecapital ratio of at least 5% and a total risk-based capital ratio of at least10%.  These are the requirements thatwere in effect at March 31, 2010 and the Bank’s ratios were in excess ofthe ratios otherwise required under the capital adequacy requirements.  The requirement to meet and maintain aspecific capital level means that the Bank may not be deemed to bewell-capitalized for the purposes of prompt corrective action.

 

TheBank Order also states that by June 30, 2010, the Bank shall submit to theOTS a written capital plan to achieve and maintain the foregoing capitallevels.  At a minimum, the plan shall: (i) address the amount ofadditional capital that will be necessary to meet the foregoing capital levelsunder different, progressively stressed economic environments; (ii) addressthe requirements and restrictions imposed by the Order and the Bank’s mostrecent examination; (iii) address the Bank’s level of classified assets,allowance for loan and lease losses, earnings, asset concentrations, liquidityneeds, and trends in this area;  (iv) addresscurrent and projected trends in real estate market conditions; (v) addressthe Bank’s capital preservation and enhancement strategies; and (vi) identifyspecific sources of additional capital and the timeframes and methods by whichadditional capital will be raised.

 

Underthe regulatory framework for prompt corrective action, the Bank’s capitalstatus may preclude the Bank from access to borrowings from the Federal ReserveSystem through the discount window. Also, as required by the framework, theBank must submit to the OTS a written capital plan as described above.  The Bank believes it can attain these ratiosby December 31, 2010 through improved operating results, shrinkage inasset size, potential branch sales, and raising capital in the third or fourthquarter of 2010.  Management’s plan issubject to economic conditions and assumes no significant further deteriorationof the Bank’s loan portfolio.

 

**DividendRestrictions.**  The principalsource of the Company’s revenues is dividends from the Bank.  The Company’s ability to pay dividends to ourshareholders depends to a large extent upon the dividends we receive from theBank.  On November 19, 2009, the OTSissued written directives to the Company and the Bank which require the Companyand the Bank to obtain prior written non-objection of the OTS in order to makeor declare any dividends or payments on their outstanding securities.

 

**Note 12 — Subsequent Events**

 

The Bank is a participant ina non-contributory multiemployer defined benefit pension plan covering allqualified employees.  On April 30,2010, the Board of Directors of the Bank elected to freeze the plan effective July 1,2010.  Freezing the plan eliminates allfuture benefit accruals for participants in the plan and closes the plan to newparticipants as of that date.  After July 1,2010, the Bank will continue to incur costs consisting of administration andPension Benefit Guaranty Corporation insurance expenses as well as amortizationcharges based on the funding level of the plan.

 

On April 30, 2010, the Boardof Directors of the Company approved the cancellation of the Company’s treasuryshares and the return of such shares of common stock to the status ofauthorized but unissued.

 

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**Item 2.  MANAGEMENT’S DISCUSSIONAND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**EXECUTIVE SUMMARY**

 

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

 

The Bank is a federally chartered stocksavings and loan association that was formed in 1934.  First Federal conducts business from its mainoffice and nineteen full-service branch offices, all of which are located in asix county area in Northcentral and Northwest Arkansas comprised of Benton,Marion, Washington, Carroll, Baxter and Boone counties. The Bank’s focus will continuein this six county area.  The Bank is acommunity-oriented financial institution offering a wide range of retail andcommercial deposit accounts, including noninterest bearing and interest bearingchecking, savings and money market accounts, certificates of deposit, andindividual retirement accounts.  Loanproducts offered by the Bank include residential real estate, consumer,construction, lines of credit, commercial real estate and commercial businessloans. However, the Bank is currently subject to comprehensive lendingrestrictions as a result of the provisions of the Bank Order.  See “Regulatory Enforcement Actions” on thefollowing page for further information. Other financial services includeinvestment products offered through First Federal Investment Services, Inc.;automated teller machines; 24-hour telephone banking; internet banking,including account access, e-statements, bill payment and online loanapplications; Bounce ProtectionTM overdraft service; debitcards; and safe deposit boxes.

 

First Federal’s lending focus hastraditionally been on permanent residential real estate.  However, between 2003 and 2005, an increasedemphasis was placed on commercial real estate lending and construction lendingbased on opportunities in Washington and Benton counties.  Beginning in late 2005, we reduced our focuson construction lending due to an oversupply of homes and lots in NorthwestArkansas.  While oversupply continues tobe a significant issue, the market in Northwest Arkansas continues to outperformthe national and state economies with lower unemployment and continuedpopulation growth. Washington and Benton County are the headquarters of thestate’s two largest employers, Wal-Mart and Tyson Foods.  These employers attract suppliers who establishoffices in the area and create jobs, fostering demand for housing and officespace.  As of February 2010,unemployment in the Fayetteville/Springdale/Rogers metro area was 7.0% (notseasonally adjusted), compared to the Arkansas rate of 7.7% and the U.S. rateof 9.7%, both seasonally adjusted.

 

Certificates of deposit continue to comprisethe majority of our deposit accounts. However, in recent years, increased emphasis has been placed on growthin checking accounts.   The Bank focusedits marketing efforts to increase checking accounts by offering a checkingproduct which has a higher interest rate than the Bank’s other checking accountproducts. To earn the maximum rate under the new product, customers mustqualify based on usage of electronic banking services such as debit cardtransactions, e-statements, and direct deposits or automatic payments. The Bank will continue to promote checking accounts as they are anattractive source of funds for the Bank as they offer overall low-interestdeposits, fee income potential, and the opportunity to cross-sell otherfinancial services.

 

The Company’s results of operations dependprimarily on its net interest income, which is the difference between interestincome on interest earning assets, such as loans and investments, and interestexpense on interest bearing liabilities, such as deposits and borrowings.  Net interest income is affected by the levelof nonperforming assets as they provide no interest earnings to the Bank.  The Company’s results of operations are also affectedby the provision for loan losses, the level of its noninterest income andexpenses, and income tax expense.

 

Noninterest income is generated primarilythrough deposit account fee income, profit on sale of loans, loan fee income,and earnings on life insurance policies.

 

Noninterest expense consists primarily ofemployee compensation and benefits, office occupancy expense, data processingexpense, real estate owned expense, net, and other operating expense.

 

Like many banks, First Federal Bank’sgreatest challenge in this economic environment is reducing the level ofnonperforming assets and managing both interest rate risk and assetquality.  We strive to maintain the assetquality of our loan portfolio at acceptable levels through sound underwritingprocedures, including the use of credit scoring; a thorough loan reviewfunction; active collection procedures for delinquent loans; and, in the eventof repossession, prompt and efficient liquidation of real estate, automobilesand other forms of collateral.   We haveexperienced a significant increase in nonperforming assets, primarily due tothe housing market oversupply issue in Northwest Arkansas as well as thedownturn in the general economy.  Weattempt to work with troubled borrowers to return their

 

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loans to performing status where possible.However, given current market conditions, the trend of increasing nonperformingassets may continue for the foreseeable future. Both the board of directors and senior management place a high priorityon reducing our nonperforming assets and managing asset quality.

 

In addition, management is also challenged withmanaging interest rate risk.  The Bank’scurrent interest rate risk position as measured by our regulator, the OTS, isat a minimal level as defined by Thrift Bulletin 13a.  The movement of interest rates impacts thelevel of interest rate risk and the timing and magnitude of assets repricingcompared to liabilities repricing.  TheBank attempts to reduce the impact of changes in interest rates on its netinterest income by managing the repricing gap.

 

**Corporate Overview and StrategicInitiatives**

 

**Overview.**  As a community-oriented financial institutionserving the borrowing and deposit needs of its primary market area ofNorthcentral and Northwest Arkansas, the Bank’s loan portfolio grew as areflection of the economic strength and expansion of its primary marketarea.  Between December 31, 2002 andDecember 31, 2005, the Bank’s loan portfolio grew from $507.0 million to$790.6 million, primarily as a result of increased construction, commercialreal estate, and land lending. However, beginning in late 2005, the Bank beganto note an oversupply of homes and lots in the Northwest Arkansas market andlimited its construction loan activity. Construction loan originations dropped from $195.8 million in 2005 to$93.6 million in 2006, $39.0 million in 2007, $15.1 million in 2008, and $12.5million in 2009.  This oversupply and,beginning in 2007, the current recession, resulted in an increase innonperforming assets, which amounted to $80.2 million or 11.50% of total assetsat March 31, 2010 compared to $78.0 million or 10.67% of total assets at December 31,2009.  As discussed further below,management has taken various actions to address its operational issues and willcontinue to devote substantial resources toward the resolution of alldelinquent and nonperforming assets.

 

**Regulatory Enforcement Actions.**

The OTS is theprimary federal regulator of the Bank. As a result of the loss in 2009 and the increase in nonperforming assetsand based on a regulatory examination of the Company and the Bank in the fall of2009, on April 12, 2010, the Company and the Bank each consented to theterms of Cease and Desist Orders issued by the OTS.  The Orders became effective on April 14,2010.

 

TheCompany Order, among other things, provides that:

 

·                  By June 30,2010, the Company shall submit to the OTS a written capital plan to preserveand enhance the capital of the Company and the Bank to ensure that the Bankcomplies with the capital requirements imposed by the Bank Order.  Ata minimum, the plan shall: (i) address the requirements and restrictionsimposed by the Orders; (ii) detail the Company’s capital preservation andenhancement strategies; (iii) identify specific sources of additionalcapital and the timeframes and methods by which additional capital will beraised; (iv) establish an alternative strategy, which includes, but is notlimited to, seeking a merger or acquisition partner for the Company and/or theBank to be implemented if the primary strategy to raise additional capital isunsuccessful; and (v) require management to submit monthly reports to theBoard regarding the Company and the Bank’s compliance with their respectivecapital plans.

 

·                  By June 30,2010, the Company shall submit to the OTS a business plan for the remainder ofthe calendar year 2010 and calendar years 2011 and 2012 that is acceptable tothe OTS Regional Director.  At a minimum,the plan shall include: (i) actions to address the requirements containedin the Order issued to the Company and the comments contained within theCompany’s most recent examination by the OTS; (ii) strategies for capitalenhancement with the capital maintenance requirements of the foregoing capitalplan; (iii) plans and strategies to strengthen and improve theconsolidated Company’s operations, earnings and profitability; (iv) adetailed discussion of the Company’s current financial position and resources; (v) quarterlypro forma financial projections; (vi) identification of all relevantassumptions and documentation; (v) a contingency plan that addresses,under different, progressively stressed economic environments: projected shortand long-term sources of liquidity and cash flow; the payment of the Company’soperating expenses; and the payment of dividends on preferred stock withoutreliance on capital distributions or any other payments from the Bank.

 

·                  Effectiveimmediately, the Company shall not declare or pay any cash dividends or capitaldistributions on the Company’s stock or repurchase such shares without theprior written non-objection of the OTS.

 

·                  Effectiveimmediately, the Company shall not issue a new class of stock or change theterms of any existing classes of stock, or convert any class of stock intoanother class of stock without the prior written non-objection of the OTS.

 

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·                  Effective immediately, the Company shall notincur, renew or increase any debt without the prior written non-objection ofthe OTS.

 

·                  Effective immediately, theCompany shall not enter into, renew, extend or revise any contractualarrangements related to compensation or benefits with any director or seniorexecutive officer of the Company without first providing OTS prior writtennotice.

 

·                  Effective immediately, theCompany shall not make any “golden parachute payment” or any prohibitedindemnification payment unless the Company complies with 12 C.F.R. Part 359.

 

·                  Effective immediately, theCompany shall comply with the OTS prior notification requirements for changesin directors and senior executive officers set forth in 12 C.F.R. Part 563,Subpart H.

 

·                  Effective immediately, theCompany shall not engage in any new transactions with the Bank except exempttransactions under 12 C.F.R. 223 and intercompany cost-sharing transactions andtax sharing transactions without the prior written non-objection of the OTS.

 

The Company Order will remain in effect until terminated, modified orsuspended by the OTS.

 

Among other things, the Bank Order provides that:

 

·                  No later than December 31,2010, the Bank shall achieve and maintain a Tier 1 (Core) Capital Ratio of atleast 8.0% and a Total Risk-Based Capital Ratio of at least 12.0%.

 

·                  By June 30, 2010, theBank shall submit to the OTS a written capital plan to achieve and maintain theforegoing capital levels.  At a minimum, the plan shall address: (i) theamount of additional capital that will be necessary to meet the foregoingcapital levels under different, progressively stressed economic environments; (ii) therequirements and restrictions imposed by the Order and the Bank’s most recentexamination; (iii) the Bank’s level of classified assets, allowance forloan and lease losses (“ALLL”), earnings, asset concentrations, liquidityneeds, and trends in these areas;  (iv) currentand projected trends in real estate market conditions; (v) the Bank’scapital preservation and enhancement strategies; and (vi) identifyspecific sources of additional capital and the timeframes and methods by whichadditional capital will be raised.

 

·                  In the event the Bank failsto meet the capital requirements of the Order, fails to comply with the capitalplan or at the request of the OTS, the Bank shall prepare and submit acontingency plan to the OTS within 30 days of such event. The contingency planshall detail actions to be taken to achieve either a merger or acquisition ofthe Bank by another depository institution or a voluntary liquidation of theBank.

 

·                  Effective immediately, theBank shall not, without the prior written non-objection of the OTS, increaseits total assets during any quarter in excess of an amount equal to netinterest credited on deposit liabilities during the prior quarter.

 

·                  By June 30, 2010, theBank shall submit to the OTS a new business plan and budget for the remainderof the calendar year 2010 and calendar years 2011 and 2012 that is acceptableto the OTS Regional Director.  At aminimum, the plan shall include: (i) plans and strategies to restructurethe Bank’s operations, improve earnings, reduce expenses and achieve positivecore income; (ii) strategies for ensuring the Bank has the financial andpersonnel resources necessary to implement and adhere to the plan; (iii) quarterlypro forma financial projections; and (iv) identification of all relevantassumptions made in formulating the plan.

 

·                  Effective immediately, theBank shall not accept, renew or roll over any brokered deposit without aspecific waiver from the OTS and the FDIC.

 

·                  Effective immediately, theBank shall develop an internal system to monitor the interest rates offered onall interest bearing accounts to ensure compliance with 12 C.F.R. 337.6(b).

 

·                  Effective immediately, theBank shall review its liquidity position and prepare a daily liquidity reportsetting forth the uses and sources of funds for the Bank’s operations and cashflow projections for a 180 day period.  The liquidity report is required to be submitted daily to the OTSRegional Director and the Bank’s Asset/Liability Committee.

 

·                  Effective immediately, theBank shall not declare or pay dividends or make any other capital distributionswithout the prior written approval of the OTS.

 

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·                  Effective immediately, the Bank shall notmake, purchase, or commit to make or purchase a commercial real estate (CRE)loan or an extension of credit for the purpose of land acquisition,development, and/or construction without the prior written non-objection of theOTS, except for construction of an owner occupied one-to-four family dwellingwith at least a 20 percent down payment or that is subject to a bindingpre-sold commitment.

 

·                  Effective immediately, the Bank shall notmake, purchase, or refinance or commit to make, purchase, or refinance anextension of credit if any of the proceeds of the loan will be used for thepayment of interest on any loan or will be used for the establishment of aninterest carry reserve on a loan without the prior written non-objection of theOTS.

 

·                  Effective immediately, the Bank shall not makeor purchase, or commit to make or purchase an extension of credit that is inexcess of the supervisory loan-to-value limits set forth in the Appendix to 12C.F.R. 560.101 without the prior written non-objection of the OTS.

 

·                  Within twenty-five (25) daysafter the end of each quarter, beginning with the quarter ended March 31,2010, the Bank shall submit a written report to the Bank’s Board of Directorssetting forth the ALLL analysis for the Bank’s assets and all assumptions usedto determine the adequacy of the ALLL, given current economic conditions andthe Bank’s risk profile.  The writtenreport is required to be submitted to the OTS Regional Director within thirty(30) days after the end of each quarter. This report was submitted as required.

 

·                  Effective immediately, theBank shall evaluate and classify its assets and establish ALLL and specificvaluation allowances in accordance with applicable laws, regulations, andregulatory guidance.

 

·                  Effective immediately, theBank shall implement and maintain an internal asset review program independentof the loan underwriting and approval functions to identify and grade loanswith potential credit weaknesses in accordance with applicable regulations andregulatory guidance regarding internal asset reviews.

 

·                  By April 1, 2010, theBank shall engage a qualified independent consultant to perform an on-siteinternal asset review and analyses of the assets on the Bank’s books as of December 31,2009, including: (i) all non-owner occupied mortgage loans exceeding twohundred fifty thousand dollars ($250,000); (ii) all other nonhomogeneousloans exceeding five hundred thousand dollars ($500,000); and (iii) allhomogeneous loans designated as special mention or watch exceeding five hundredthousand dollars ($500,000). The review shall be completed by May 31, 2010and the Bank shall submit the consultant’s report to the OTS by June 30,2010.  The Bank has already engaged aqualified independent consultant to meet this requirement.

 

·                  By June 30, 2010, theBank shall submit a comprehensive classified asset reduction plan to reduceclassified assets that is acceptable to the OTS Regional Director. At aminimum, such plan shall include: (i) targets for the level of classifiedassets as a percentage of Tier 1 (Core) capital and ALLL and the timeframe foreach such target; (ii) a description of the manner of, and methods for,reducing the Bank’s level of classified assets to the targets set forththerein; and (iii) all relevant assumptions and projections based ondifferent scenarios, and documentation supporting such assumptions andprojections.

 

·                  By June 30, 2010, theBank shall submit a Loan-to-Value Plan to reduce the aggregate amount of allloans in excess of the supervisory loan-to-value limits set forth in theAppendix to 12 C.F.R. 560.101.  At aminimum, the plan shall include: (i) targets for the aggregate amount ofall loans in excess of such supervisory loan-to-value limits; (ii) targetsfor the aggregate amount of all commercial loans, agricultural loans,multifamily loans, or loans secured by properties other than owner occupiedone-to-four family residential properties in excess of such supervisoryloan-to-value limits; (iii) a description of the manner of, and methodsfor, reducing the Bank’s level of loans in excess of such supervisoryloan-to-value limits to the targets set forth therein; and (iv) allrelevant assumptions and projections based on a best-case scenario, aworst-case scenario, and a most probable case scenario, and documentationsupporting such assumptions and projections.

 

·                  By May 31, 2010, theBank will submit to the OTS a certified written report regarding thetransactions that do not comply with the requirements of 12 U.S.C. 1464 and 12C.F.R. 560.30, specifically related to all real estate transactions and realestate transfer transactions conducted from January 1, 2008 through January 31,2010.

 

·                  By June 30, 2010, theBank shall submit a plan to divest of any impermissible asset that isacceptable to the OTS Regional Director.

 

·                  By June 30, 2010, the Bank shall submit acommercial real estate concentration plan to the OTS, subject to OTS RegionalDirector acceptance, that, at a minimum, addresses: (i) the reduction ofthe amount of the Bank’s existing CRE loans to two hundred percent (200%) orless of Tier 1 (Core) capital and ALLL; (ii) the 

 

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reduction of each category of assets within the CREportfolio to one hundred percent (100%) or less of Tier 1 (Core) capital andALLL; (iii) the time frames for reaching each such target; and (iv) theassessment, monitoring, and control of the risks associated with the Bank’s CREportfolio in accordance with applicable regulatory guidance.

 

·                  Effective immediately, the Bank shall notengage in any new transaction with an affiliate unless the Bank has compliedwith certain regulatory requirements.

 

·                  Effective immediately, the Bank shall notenter into any arrangement or contract with a third party service provider thatis significant to the overall operation or financial condition of the Bank oroutside the Bank’s normal course of business without obtaining writtennon-objection from the OTS.

 

·                  Effective immediately, the Bank shall notenter into, renew, extend or revise any contractual arrangement relating tocompensation or benefits for any senior executive officer or director unlessprior written notice is provided to the OTS.

 

·                  Effective immediately, the Bank shall notincrease any salaries, bonuses or director’s fees or make any other similarpayments to directors or senior executive officers without prior writtennon-objection from the OTS.

 

·                  Effective immediately, the Bank shall not makeany “golden parachute payments” or prohibited indemnification payment unlessthe Bank has complied with 12 C.F.R. Part 359 and 12 C.F.R. Section 545.121.

 

·                  Effective immediately, the Bank shall complywith the prior notification requirements for changes in directors and seniorexecutive officers set forth in 12 C.F.R. Part 563, Subpart H.

 

·                  By April 30, 2010, the Bank shall retainan independent third party consultant acceptable to the OTS Regional Directorto conduct a review of supervision of the Bank’s lending operations by theBoard and management. At a minimum, the Management Study shall include: (i) theidentification of present and future staffing requirements for the Bank’slending operations; (ii) an evaluation of the performance of managementwith respect to the Bank’s lending operations, including an assessment ofwhether compensation is commensurate with job performance and responsibilitiesin compliance with 12 C.F.R. § 563.161(b); (iii) the establishment ofstandards by which management’s effectiveness in the Bank’s lending operationswill be measured; (iv) an assessment of the adequacy of communicationregarding the Bank’s lending operations between management and the Board andthe quality and timeliness of reporting to the Board; and (v) recommendationson whether to expand the scope, frequency, and sufficiency of informationregarding the Bank’s lending operations provided to the Board by management. ByJuly 30, 2010, the Board shall adopt a written plan to address anyidentified weaknesses or deficiencies noted in such study. The Bank shallprovide such plan to the OTS within fifteen (15) days after the board meeting.   The Bank retained the independent thirdparty consultant and this consultant has already begun work towards compliancewith this requirement of the Bank Order.

 

The Bank Order will remain in effect until terminated, modified orsuspended by the OTS.  Copies of thestipulations and the Orders are included as Exhibits 10.7 to 10.10 to theCompany’s 2009 Annual Report on Form 10-K filed with the SEC on April 15,2010.  The descriptions of the Orders setforth herein do not purport to be complete, and are qualified by reference tothe full text of the Orders.

 

The Company and the Bank have taken such actions as necessary to complywith the provisions of the Orders which are currently effective and arecontinuing to work toward compliance with the provisions of the Orders withfuture compliance dates.  Any materialfailure by the Company and the Bank to comply with the provisions of the Orderscould result in further enforcement actions by the OTS. While the Company andthe Bank intend to take such actions as may be necessary to comply with therequirements of the Orders, there can be no assurance that the Company or theBank will be able to comply fully with the Orders, or that efforts to complywith the Orders will not have adverse effects on the operations and financialcondition of the Company or the Bank. See “Risk Factors.”

 

**Report of Independent Registered Public Accounting Firm.**The report ofthe Company’s independent registered public accounting firm for the year ended December 31,2009 contained an explanatory paragraph as to the Company’s ability to continueas a going concern primarily due to the Company’s loss of $45.5 million in2009, the Bank’s significant level of criticized assets and the decline in theBank’s capital position.  See Note 2 ofthe Notes to the Unaudited Condensed Consolidated Financial Statements includedin Part I, Item 1 herein.

 

**Strategic Initiatives. **In response tothe operational issues which have arisen as a result of the level of the Bank’snonperforming assets and the difficult economic and banking environment,management has taken a number of cost saving actions, implemented variousstrategic initiatives and aggressively addressed the nature and level of itsnonperforming assets.

 

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During 2009, the Company reviewed all aspects of its cost structure andimplemented the following cost saving measures which continue in 2010:

·                  Reductions incompensation and benefits through

·                  decreasedexecutive and senior management salaries,

·                  reduced directorfees,

·                  reduced staffinglevels,

·                  eliminatedCompany’s 401(k) match,

·                  suspended payincreases and bonuses;

·                  Reductions indiscretionary expenses such as travel and entertainment, professional educationand contributions;

·                  Reductions inadvertising and public relations costs; and

·                  Reductions inthird-party contract provider costs.

 

In order to complement the cost saving of the actions described aboveand to provide the Company with greater operational flexibility, the Companyhas taken the following actions:

·                  Significantlyreduced lending, particularly construction and land loans;

·                  Increasedliquidity;

·                  Suspended cashdividends on common and preferred stock; and

·                  Maintained thelevel of its interest rate spread and net interest margin.

 

The Company continues to work through the credit problems presented bythe oversupply of homes and lots in the Company’s Northwest Arkansas marketarea, the housing market downturn and current market conditions.  In order to address the Company’snonperforming assets, the Company has taken the following steps in 2010:

·                  Hired anindependent third party contractor to conduct a thorough review and analysis ofits loan portfolio, including a review of collateral valuations;

·                  Hired anexperienced former bank regulator as the Bank’s Credit Risk and Loan ReviewManager; and

·                  Hired anAppraisal Review Officer.

 

During 2010, the Company intends to continue to proactively address thechallenges presented by the economy.  TheCompany will focus on the following primary objectives during 2010:

·                  Addressing andresolving problem assets;

·                  Further reducingcosts to achieve greater efficiency;

·                  Addressing andcomplying with all terms and conditions of the Orders; and

·                  Raising capital.

 

The Orders require the Company and the Bank to, among other things,submit a capital plan to the OTS to preserve and enhance the capital of theCompany and the Bank.  In addition, theBank Order requires the Bank to achieve and maintain a tier one core capitalratio and a total risk-based capital ratio of at least 8% and 12%,respectively, by December 31, 2010. While the Company will consider all strategic alternatives available toit, including the reduction of assets, the Company currently intends to raisecapital in the third or fourth quarter of 2010.

 

## **CRITICAL ACCOUNTING POLICIES**

##  

Various elements of our accountingpolicies, by their nature, are inherently subject to estimation techniques,valuation assumptions and other subjective assessments.  In particular, the following estimates, dueto the judgments, estimates and assumptions inherent in those policies, arecritical to preparation of our financial statements.

 

·                  Determinationof our allowance for loan losses

·                  Valuationof real estate owned

·                  Valuationof our deferred tax assets

 

These policies and the judgments,estimates and assumptions are described in greater detail in subsequentsections of Management’s Discussion and Analysis and in the notes to theunaudited condensed consolidated financial statements included herein. Webelieve that the judgments, estimates and assumptions used in the preparationof our consolidated financial statements are appropriate given the factualcircumstances at the time.  However,given the sensitivity of our consolidated financial statements to thesecritical accounting policies, the use of other judgments, estimates and assumptionscould result in material differences in our results of operations or financialcondition.

 

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In estimating the amount of creditlosses inherent in our loan portfolio, various judgments and assumptions aremade.  For example, when assessing thecondition of the overall economic environment, assumptions are made regardingmarket conditions and their impact on the loan portfolio.  In the event the economy were to sustain aprolonged downturn, the loss factors applied to our portfolios may need to berevised, which may significantly impact the measurement of the allowance forloan losses.  For impaired loans that arecollateral dependent and for real estate owned, the estimated fair value of thecollateral may deviate significantly from the proceeds received when thecollateral is sold.

 

We recognize deferred tax assets and liabilities for the future taxconsequences related to differences between the financial statement carryingamounts of existing assets and liabilities and their respective tax bases, andfor tax credits. We evaluate our deferred tax assets for recoverability using aconsistent approach that considers the relative impact of negative and positiveevidence, including our historical profitability and projections of futuretaxable income. We are required to establish a valuation allowance for deferredtax assets if we determine, based on available evidence at the time thedetermination is made, that it is more likely than not that some portion or allof the deferred tax assets will not be realized. In evaluating the need for avaluation allowance, we estimate future taxable income based onmanagement-approved business plans and ongoing tax planning strategies. Thisprocess involves significant management judgment about assumptions that aresubject to change from period to period based on changes in tax laws orvariances between our projected operating performance, our actual results andother factors.

 

**CHANGES IN FINANCIAL CONDITION**

 

Changes in financialcondition between March 31, 2010 and December 31, 2009 are presentedin the following table (dollars in thousands). Material changes between the periods are discussed in the sections whichfollow the table.

 
| ** **                                    | ** ** | **March 31****,** | ** ** | **December 31,** | ** ** | **Increase**   | ** ** | **Percentage** | ** ** |
|-----------------------------------------------|------------|------------------------|------------|-----------------------|------------|----------------|------------|----------------|------------|
| ** **                                    | ** ** | **2010**               | ** ** | **2009**              | ** ** | **(Decrease)** | ** ** | **Change**     | ** ** |
| **ASSETS**                                    |       |                   |       |                  |       |           |       |           |       |
| Cash and cash equivalents                     |       | $                      | 29,387     |                  | $          | 22,149         |       | $              | 7,238      |   | 32.7 | % |
| Investment securities held to maturity        |       | 119,262                |       | 135,531               |       | (16,269        | )          | (12.0          | )          |
| Federal Home Loan Bank stock                  |       | 2,422                  |       | 3,125                 |       | (703           | )          | (22.5          | )          |
| Loans receivable, net                         |       | 460,104                |       | 481,542               |       | (21,438        | )          | (4.5           | )          |
| Loans held for sale                           |       | 395                    |       | 1,012                 |       | (617           | )          | (61.0          | )          |
| Accrued interest receivable                   |       | 3,672                  |       | 4,229                 |       | (557           | )          | (13.2          | )          |
| Real estate owned, net                        |       | 33,623                 |       | 35,155                |       | (1,532         | )          | (4.4           | )          |
| Office properties and equipment, net          |       | 23,236                 |       | 23,567                |       | (331           | )          | (1.4           | )          |
| Prepaid expenses and other assets             |       | 24,828                 |       | 24,760                |       | 68             |       | 0.3            |       |
|                                          |       |                   |       |                  |       |           |       |           |       |
| TOTAL                                         |       | $                      | 696,929    |                  | $          | 731,070        |       | $              | (34,141    | ) | (4.7 | )% |
|                                          |       |                   |       |                  |       |           |       |           |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY** |       |                   |       |                  |       |           |       |           |       |
| LIABILITIES:                                  |       |                   |       |                  |       |           |       |           |       |
| Deposits                                      |       | $                      | 613,104    |                  | $          | 624,624        |       | $              | (11,520    | ) | (1.8 | )% |
| Other borrowings                              |       | 35,526                 |       | 59,546                |       | (24,020        | )          | (40.3          | )          |
| Other liabilities                             |       | 4,300                  |       | 3,600                 |       | 700            |       | 19.4           |       |
|                                          |       |                   |       |                  |       |           |       |           |       |
| Total liabilities                             |       | 652,930                |       | 687,770               |       | (34,840        | )          | (5.1           | )          |
|                                          |       |                   |       |                  |       |           |       |           |       |
| STOCKHOLDERS’ EQUITY                     |       | 43,999                 |       | 43,300                |       | 699            |       | 1.6            |       |
|                                          |       |                   |       |                  |       |           |       |           |       |
| TOTAL                                         |       | $                      | 696,929    |                  | $          | 731,070        |       | $              | (34,141    | ) | (4.7 | )% |
|                                          |       |                   |       |                  |       |           |       |           |       |
| BOOK VALUE PER COMMON SHARE                   |       | $                      | 5.73       |                  | $          | 5.59           |       |           |       |   |   |
|                                          |       |                   |       |                  |       |           |       |           |       |
| COMMON EQUITY TO ASSETS                       |       | 4.0                    | %          | 3.7                   | %          |           |       |           |       |
|                                          |       |                   |       |                  |       |           |       |           |       |
| TOTAL EQUITY TO ASSETS                        |       | 6.3                    | %          | 5.9                   | %          |           |       |           |       |

 

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**LoansReceivable. **Changes in loan composition between March 31,2010 and December 31, 2009 are presented in the following table (dollarsin thousands).

 
| ** **                                       | ** ** | **March 31,** | ** ** | **December 31,** | ** ** | **Increase**   | ** ** | ** **   | ** ** |
|--------------------------------------------------|------------|--------------------|------------|-----------------------|------------|----------------|------------|--------------|------------|
| ** **                                       | ** ** | **2010**           | ** ** | **2009**              | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
|                                             |       |               |       |                  |       |           |       |         |       |
| One- to  four-family residences                  |       | $                  | 234,588    |                  | $          | 235,990        |       | $            | (1,402     | ) | (0.6 | )% |
| Home equity  lines of credit and second mortgage |       | 24,022             |       | 27,022                |       | (3,000         | )          | (11.1        | )          |
| Multifamily                                      |       | 24,285             |       | 25,368                |       | (1,083         | )          | (4.3         | )          |
| Commercial real  estate                          |       | 106,810            |       | 107,237               |       | (427           | )          | (0.4         | )          |
| Land                                             |       | 40,030             |       | 41,405                |       | (1,375         | )          | (3.3         | )          |
| Construction:                                    |       |               |       |                  |       |           |       |         |       |
| One- to  four-family residences                  |       | 5,511              |       | 7,102                 |       | (1,591         | )          | (22.4        | )          |
| Speculative  one-to four-family residences       |       | 6,959              |       | 8,849                 |       | (1,890         | )          | (21.4        | )          |
| Multifamily                                      |       | 13,628             |       | 14,178                |       | (550           | )          | (3.9         | )          |
| Commercial real  estate                          |       | 1,772              |       | 9,717                 |       | (7,945         | )          | (81.8        | )          |
| Land development                                 |       | 8,974              |       | 9,449                 |       | (475           | )          | (5.0         | )          |
| Total  construction loans                        |       | 36,844             |       | 49,295                |       | (12,451        | )          | (25.3        | )          |
| Total mortgage  loans                            |       | 466,579            |       | 486,317               |       | (19,738        | )          | (4.1         | )          |
|                                             |       |               |       |                  |       |           |       |         |       |
| Commercial                                       |       | 13,352             |       | 14,575                |       | (1,223         | )          | (8.4         | )          |
|                                             |       |               |       |                  |       |           |       |         |       |
| Automobile                                       |       | 5,897              |       | 6,810                 |       | (913           | )          | (13.4        | )          |
| Other                                            |       | 9,791              |       | 11,052                |       | (1,261         | )          | (11.4        | )          |
| Total consumer                                   |       | 15,688             |       | 17,862                |       | (2,174         | )          | (12.2        | )          |
|                                             |       |               |       |                  |       |           |       |         |       |
| Total loans  receivable                          |       | 495,619            |       | 518,754               |       | (23,135        | )          | (4.5         | )          |
|                                             |       |               |       |                  |       |           |       |         |       |
| Undisbursed loan  funds                          |       | (2,842             | )          | (4,327                | )          | 1,485          |       | (34.3        | )          |
| Deferred loan  costs (fees) — net           |       | (21                | )          | 23                    |       | (44            | )          | (191.3       | )          |
| Allowance for  loan losses (1)                   |       | (32,652            | )          | (32,908               | )          | 256            |       | (0.8         | )          |
|                                             |       |               |       |                  |       |           |       |         |       |
| Loans  receivable, net                           |       | $                  | 460,104    |                  | $          | 481,542        |       | $            | (21,438    | ) | (4.5 | )% |

 

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(1)  The allowance for loan losses at March 31, 2010 and December 31,2009, is comprised of specific valuation allowances of $8.6 million and $7.5million, respectively, and general valuation allowances of $24.0 million and$25.4 million, respectively.

 

Thedecrease in the Bank’s loan portfolio was primarily due to a decrease in loanoriginations as a result of continued softening of the housing market in theBank’s market area and transfers of nonperforming loans to REO, net of loans tofacilitate sales of REO. Market data indicates an overall decrease in homesales in Benton and Washington counties in 2009, 2008 and 2007.  Although the Northwest Arkansas region’seconomy continues to experience population growth and a relatively good jobmarket, the supply of new residential lots and new speculative homes for salecontinues to outpace demand.  We expectthis trend to continue for the foreseeable future given the level of oversupplyin the market.

 

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**Asset Quality. **The following table sets forth the amounts, net ofspecific valuation allowances, and categories of the Bank’s nonperformingassets at the dates indicated (dollars in thousands).

 
| ** **                                                       | ** ** | **March 31, 2010** | ** ** | **December 31, 2009** | ** ** | **Increase** | ** ** |
|------------------------------------------------------------------|------------|-------------------------|------------|----------------------------|------------|--------------|------------|
| ** **                                                       | ** ** | **Net**                 | ** ** | **% Assets**               | ** ** | **Net**      | ** ** | **% Assets** | ** ** | **(Decrease)** | ** ** |
| Nonaccrual Loans:                                                | ** ** | ** **              | ** ** | ** **                 | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
| One- to four-family residential                                  |       | $                       | 12,721     |                       | 1.83       | %            | $          | 11,941 |   | 1.63 | % | $ | 780 |   |
| Home equity and second mortgage                                  |       | 978                     |       | 0.14                       |       | 1,174        |       | 0.16 |   | (196 | ) |
| Speculative one- to four-family construction                     |       | 849                     |       | 0.12                       |       | 1,081        |       | 0.15 |   | (232 | ) |
| Multifamily residential                                          |       | 3,939                   |       | 0.57                       |       | 1,431        |       | 0.20 |   | 2,508 |   |
| Land development                                                 |       | 5,694                   |       | 0.82                       |       | 6,144        |       | 0.84 |   | (450 | ) |
| Land                                                             |       | 14,556                  |       | 2.09                       |       | 13,709       |       | 1.88 |   | 847 |   |
| Commercial real estate                                           |       | 7,187                   |       | 1.03                       |       | 6,795        |       | 0.93 |   | 392 |   |
| Commercial loans                                                 |       | 383                     |       | 0.05                       |       | 463          |       | 0.06 |   | (80 | ) |
| Consumer loans                                                   |       | 246                     |       | 0.03                       |       | 129          |       | 0.01 |   | 117 |   |
|                                                             |       |                    |       |                       |       |         |       |   |   |   |   |
| Total nonaccrual loans                                           |       | 46,553                  |       | 6.68                       | %          | 42,867       |       | 5.86 | % | 3,686 |   |
|                                                             |       |                    |       |                       |       |         |       |   |   |   |   |
| Real estate owned                                                |       | 33,623                  |       | 4.82                       |       | 35,155       |       | 4.81 |   | (1,532 | ) |
|                                                             |       |                    |       |                       |       |         |       |   |   |   |   |
| Total nonperforming assets                                       |       | 80,176                  |       | 11.50                      |       | 78,022       |       | 10.67 |   | 2,154 |   |
| Performing restructured loans                                    |       | 4,846                   |       | 0.70                       |       | 4,609        |       | 0.63 |   | 237 |   |
|                                                             |       |                    |       |                       |       |         |       |   |   |   |   |
| Total nonperforming assets and performingrestructured  loans (1) |       | $                       | 85,022     |                       | 12.20      | %            | $          | 82,631 |   | 11.30 | % | $ | 2,391 |   |

 

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(1) The table above does not includesubstandard impaired loans of $10.6 million and $6.3 million as of March 31,2010 and December 31, 2009, respectively. These impaired loans generally include loans for which there may bedoubt about the ultimate timing of collection of principal and interestcompared to the original terms of the note but where the payment history hasbeen satisfactory and collateral coverage is estimated to be adequate to payprincipal and interest in full.  See Note7 to the unaudited condensed consolidated financial statements.  The table also does not include substandardloans which were judged not to be impaired totaling $24.3 million and $37.3million at March 31, 2010 and December 31, 2009, respectively.

 

The increasein net nonaccrual loans from $42.9 million at December 31, 2009 to $46.6million at March 31, 2010 was primarily related to an increase in nonaccrualmultifamily residential loans. The increase in nonaccrual multifamily loans wasprimarily due to a $2.9 million construction loan on a 56 unit apartmentcomplex in Rogers, Arkansas that matured April 1, 2010.  Based on estimated costs to complete theproject and a July 2009 appraisal, a specific loan loss allowance ofapproximately $600,000 was recorded for this loan as of March 31,2010.  Nonaccrual land and landdevelopment loans comprise over 43% of nonaccrual loans at March 31, 2010.Nonaccrual land and land development loans with balances in excess of $1.0million at March 31, 2010 are listed in the table below (in thousands).

 
| ** **                                              | ** ** | **Location**     | ** ** | **Date to  Nonaccrual** | ** ** | **Comments** | ** ** | **Loan  Balance** | ** ** | **Specific  Valuation  Allowance** | ** ** | **Net of  SVA** | ** ** | **Valuation  Date** | ** ** | **Source** | ** **         |
|---------------------------------------------------------|------------|------------------|------------|-------------------------|------------|--------------|------------|-------------------|------------|------------------------------------|------------|-----------------|------------|---------------------|------------|------------|--------------------|
| **Land  Development**                                   |       |             |       |                    |       |         |       |              |       |                               |       |            |       |                |       |       |               |
| 42 developed  single family lots                        |       | Cave Springs, AR |       | 3Q2007                  |       | A            |       | $                 | 1,040      |                               | $          | —          |       | $                   | 1,040      |       | November 2009 |   | F |   |
| 52 single family  lots and 25 acres of undeveloped land |       | Fayetteville, AR |       | 1Q2009                  |       | B            |       | 3,649             |       | —                             |       | 3,649           |       | November 2009  |       | F          |               |
| 40 acres,  proposed residential subdivision             |       | Farmington, AR   |       | 3Q2009                  |       | C            |       | 1,060             |       | 55                                 |       | 1,005           |       | December 2009  |       | F          |               |
|                                                    |       |             |       |                    |       |         |       | $                 | 5,749      |                               | $          | 55              |       | $                   | 5,694      |       |               |   |   |   |
| **Land**                                                |       |             |       |                    |       |         |       |              |       |                               |       |            |       |                |       |       |               |
| 80 acres for  future residential development            |       | Fayetteville, AR |       | 1Q2009                  |       | D            |       | $                 | 2,223      |                               | $          | —          |       | $                   | 2,223      |       | February 2010 |   | G |   |
| 29 acres for  future commercial development             |       | Springdale, AR   |       | 1Q2009                  |       | D            |       | 2,039             |       | 10                                 |       | 2,029           |       | March 2010     |       | G          |               |
| 24 acres,  commercial zoned                             |       | Lowell, AR       |       | 1Q2009                  |       | D            |       | 1,947             |       | —                             |       | 1,947           |       | March 2010     |       | G          |               |
| 96 developed  single family lots                        |       | Fayetteville, AR |       | 1Q2009                  |       | E            |       | 2,735             |       | 370                                |       | 2,365           |       | March 2010     |       | F          |               |
| 60 acres,  residential zoned                            |       | Fayetteville, AR |       | 1Q2009                  |       | B            |       | 2,005             |       | 777                                |       | 1,228           |       | February 2010  |       | G          |               |
| 35 acres,  proposed residential subdivision             |       | Fayetteville, AR |       | 3Q2009                  |       | C            |       | 3,447             |       | 2,308                              |       | 1,139           |       | January 2010   |       | G          |               |
| Other - 27 loans  under $1 million each                 |       |             |       |                    |       |         |       | 4,353             |       | 728                                |       | 3,625           |       |                |       |       |               |
|                                                    |       |             |       |                    |       |         |       | $                 | 18,749     |                               | $          | 4,193           |       | $                   | 14,556     |       |               |   |   |   |

 

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| A |  — |   | This loan has been  nonperforming for an extended period while the Bank exercised forbearance  with the borrowers to allow them to market and maintain the property. The  Bank is currently foreclosing on the property. |
|---|--------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| B |  — |   | These two loans are related  to the same borrower. The loans matured in January 2010 and are now in  foreclosure.                                                                                                   |
| C |  — |   | These two loans are related  to the same borrower group. These loans have been sent to legal counsel for  collection/foreclosure.                                                                                        |
| D |  — |   | These loans are all related  to the same borrower and all are in foreclosure.                                                                                                                                            |
| E |  — |   | This loan is in  foreclosure. This property is also the subject of litigation related to bonds  that were sold without satisfying the first mortgage with the Bank.                                                      |
| F |  — |   | This valuation is based on  discounted cash flow analysis.                                                                                                                                                               |
| G |  — |   | This valuation is based on  comparable sales.                                                                                                                                                                            |

 

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We expect asignificant amount of the nonaccrual real estate loans to eventually migrate toreal estate owned as $30.3 million of the nonaccrual real estate loans, net ofspecific valuation allowances of $4.6 million, are in bankruptcy or some stageof the foreclosure process as of March 31, 2010.  Therefore,we expect real estate owned and associated expenses to continue to remain atelevated levels in future periods as such loans migrate from loans to realestate owned.

 

The following table sets forth the amounts andcategories of the Bank’s real estate owned at the dates indicated.

 
| ** **                                     | ** ** | **March ****31****,********2010** | ** ** | **December 31,  2009** | ** ** | **Increase********(Decrease)** | ** ** | **Percentage  Change** | ** ** |
|------------------------------------------------|------------|----------------------------------------|------------|-----------------------------|------------|--------------------------------|------------|------------------------|------------|
| ** **                                     | ** ** | **(Dollars in Thousands)**             | ** ** | ** **                  | ** ** | ** **                     | ** ** |
| Real estate owned                              |       |                                   |       |                        |       |                           |       |                   |       |
| One- to four-family residential                |       | $                                      | 9,076      |                        | $          | 10,216                         |       | $                      | (1,140     | ) | (11.2 | )% |
| Speculative one- to four-familyconstruction(1) |       | 3,095                                  |       | 3,186                       |       | (91                            | )          | (2.9                   | )          |
| Multifamily                                    |       | 377                                    |       | 545                         |       | (168                           | )          | (30.8                  | )          |
| Land(2)                                        |       | 13,782                                 |       | 13,952                      |       | (170                           | )          | (1.2                   | )          |
| Commercial real estate                         |       | 7,293                                  |       | 7,256                       |       | 37                             |       | 0.5                    |       |
| Total real estate owned                        |       | $                                      | 33,623     |                        | $          | 35,155                         |       | $                      | (1,532     | ) | (4.4 | )% |

 

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(1)          At March 31, 2010, $2.6 million of these properties were 100%complete.  The remainder range from 73%to 98% complete.

(2)          At March 31, 2010, $8.5million of the land balance represented 294 developed subdivision lots and $2.5million represented four unimproved commercial lots. The remaining $2.8 millionconsisted of raw land.

 

The landcomponent of real estate owned is made up of the following at March 31,2010 (in thousands):

 
| ** **                                    | ** ** | **Location**    | ** ** | **Date to  real  estate owned** | ** ** | **Balance** | ** ** | **Valuation  Date** | ** ** | **Source** | ** ** |
|-----------------------------------------------|------------|-----------------|------------|---------------------------------|------------|-------------|------------|---------------------|------------|------------|------------|
|                                          |       |            |       |                            |       |        |       |                |       |       |       |
| **Land**                                      |       |            |       |                            |       |        |       |                |       |       |       |
| 35 developed single family lots               |       | Pea Ridge, AR   |       | 12/30/2008                      |       | $           | 385        |                | 1/14/2010  |       | 1          |   |
| 48 developed single family lots               |       | Elm Springs, AR |       | 10/21/2008                      |       | 1,230       |       | 1/27/2010           |       | 1          |       |
| 110 developed single family lots              |       | Springdale, AR  |       | 4/17/2008                       |       | 3,534       |       | 1/14/2010           |       | 1          |       |
| 60 developed single family lots               |       | Lowell, AR      |       | 5/30/2008                       |       | 1,662       |       | 1/15/2010           |       | 1          |       |
| 30.7 acres for future residential development |       | Lowell, AR      |       | 5/30/2008                       |       | 1,257       |       | 3/29/2010           |       | 2          |       |
| 63.3 acres for future residential development |       | Elm Springs, AR |       | 10/21/2008                      |       | 888         |       | 1/27/2010           |       | 2          |       |
| 10 developed single family lots               |       | Farmington, AR  |       | 7/2/2009                        |       | 564         |       | 12/30/2009          |       | 2          |       |
| 1 unimproved commercial lot                   |       | Rogers, AR      |       | 10/29/2009                      |       | 1,879       |       | 1/27/2010           |       | 2          |       |
| 3 unimproved commercial lots                  |       | Springdale, AR  |       | 11/19/2009                      |       | 664         |       | 1/25/2010           |       | 1          |       |
| Other - 36 properties                         |       |            |       |                            |       | 1,719       |       |                |       |       |       |
|                                          |       |            |       |                            |       | $           | 13,782     |                |       |       |       |   |

 

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1— This valuation is based on discounted cash flow.

2— This valuation is based on comparable sales.

 

The Bank isdiligently working to dispose of its REO and has several team members dedicatedto this effort, including an experienced special assets officer who is workingfull-time to liquidate the Bank’s properties in the Northwest Arkansas market.Each property is evaluated on a case-by-case basis to determine the best courseof action with respect to liquidation.  Properties are marketed directlyby the Bank or listed with local real estate agents utilizing appraisals,market information from realtors, market research reports, and our own marketevaluations to make pricing and selling decisions.  The Bank’s ChiefLending Officer, loan officers, credit manager, special assets officer, andteam members in the collections department all work together in thisendeavor.   The Bank’s goal is to liquidate these properties in anorderly and efficient manner without incurring extraordinary losses due toquick sale pricing.  During the quarter endedMarch 31, 2010, the Bank’s net sales proceeds from REO sales were $4.6million, which included $2.9 million of loans to facilitate the sales of REO.

 

**ClassifiedAssets. **Federal regulations requirethat each insured savings association classify its assets on a regularbasis.  In addition, in connection withexaminations of insured institutions, federal examiners have authority toidentify problem assets and, if appropriate, classify them.  There are three classifications for problemassets: “substandard,” “doubtful” and “loss.” Substandard assets have one or more defined weaknesses and arecharacterized by the distinct possibility that the insured institution willsustain some loss if the deficiencies are not corrected.  Doubtful assets have the weaknesses ofsubstandard assets with the additional characteristic that the weaknesses make 

 

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collection or liquidation in full on the basisof currently existing facts, conditions and values questionable, and there is ahigh possibility of loss.  An assetclassified loss is considered uncollectible and of such little value that continuanceas an asset of the institution is not warranted.  At March 31, 2010, theBank had $119.2 million of classified assets, all of which were classified assubstandard, including $46.6 million of nonaccrual loans and $33.6 million ofreal estate owned.  Substandard loansinclude $39.0 million of loans not included in the nonperforming assetstable.  Such loans have been reviewed anddetermined not to be impaired or if impaired, were estimated to have noloss.  As a result, such loans remainedon accrual status at March 31, 2010.

 

In addition, at March 31, 2010, theBank had $41.5 million of assets designated as special mention. Special mentionassets have potential weaknesses that deserve management’s closeattention.  If left uncorrected, thesepotential weaknesses may result in deterioration of the repayment prospects forthe asset or the institution’s credit position at some future date.

 

**Potential Problem Loans.**   Basedon the oversupply of lots in Northwest Arkansas, our land development portfolioposes a higher risk of default.  These loansare typically structured with interest due at maturity and lot sales as thesource of repayment.  Since lot sales inthe 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 March 31, 2010,gross land development loans totaled $9.0 million.  Of this total, $5.7 million is on nonaccrualstatus with $1.2 million in nonaccrual interest, and $3.1 million with $22,000in accrued interest is classified as substandard and remains on accrual.

 

**Delinquent Loans.**  The following table represents loans past due30 — 89 days not on nonaccrual status as of March 31, 2010 and December 31,2009 (in thousands).  The amountspresented represent the total outstanding principal balances of the relatedloans, rather than the actual payment amounts that are past due.

 
| ** **                      | ** ** | **March 31, 2010** | ** ** | **December 31, 2009** | ** ** |
|---------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| One- to four-family residential |       | $                            | 4,468      |                            | $          | 2,759 |   |
| Home equity and second mortgage |       | 557                          |       | 201                             |       |
| Multifamily residential         |       | 22                           |       | —                          |       |
| Land                            |       | 781                          |       | 1,156                           |       |
| Commercial real estate          |       | 3,491                        |       | 974                             |       |
| Commercial loans                |       | 707                          |       | 1,668                           |       |
| Consumer loans                  |       | 176                          |       | 118                             |       |
|                            |       | $                            | 10,202     |                            | $          | 6,876 |   |
|                            |       |                         |       |                            |       |
| Percentage of Portfolio         |       | 2.06                         | %          | 1.33                            | %          |

 

Past due loans not on nonaccrualstatus are up since December 31, 2009 in the categories of single family,home equity and commercial real estate loans. We believe the negative trend in the single family and home equitycategories is due to economic conditions and we have provided for this in ourGeneral Valuation Allowances (“GVA”) in these categories accordingly.  Past due commercial real estate loans are upat March 31, 2010 compared to December 31, 2009 due to a $2.8 millionloan collateralized by two commercial buildings that was 30 days past due as ofMarch 31, 2010.  The borroweroperates a furniture store and has struggled to stay current on the loan, primarilydue to the effect economic conditions have had on his business.  We have obtained appraisals on the propertieswithin the past year and updated them this quarter.  Based on the appraisals and related update,we do not expect to incur a significant loss on this loan.

 

**Allowance for Loan Losses**. A summary of the activity in the allowance for loan losses is asfollows (in thousands):

 
| ** **                      | ** ** | **Three Months Ended****March 31****,** | ** ** |
|---------------------------------|------------|----------------------------------------------|------------|
| ** **                      | ** ** | **2010**                                     | ** ** | **2009** | ** ** |
| Balance at beginning of period  |       | $                                            | 32,908     |   | $ | 6,441 |   |
| Provisions for estimated losses |       | 53                                           |       | 3,521 |   |
| Recoveries                      |       | 70                                           |       | 60 |   |
| Losses charged off              |       | (379                                         | )          | (464 | ) |
| Balance at end of period        |       | $                                            | 32,652     |   | $ | 9,558 |   |

 

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A summary of the activity in the allowancefor losses by category for the three months ended March 31, 2010 is presented below (in thousands):

 
| ** **                                   | ** ** | **December 31,** | ** ** | ** **          | ** ** | ** **     | ** ** | ** **     | ** ** | **March 31,** | ** ** |
|----------------------------------------------|------------|-----------------------|------------|---------------------|------------|----------------|------------|----------------|------------|--------------------|------------|
| ** **                                   | ** ** | **2009**              | ** ** | **Charge-offs (1)** | ** ** | **Recoveries** | ** ** | **Provisions** | ** ** | **2010**           | ** ** |
| One- to four-family residential              |       | $                     | 4,436      |                | $          | (81            | )          | $              | 9          |               | $          | — |   | $ | 4,364 |   |
| Home equity and second mortgage              |       | 1,688                 |       | (78                 | )          | 2              |       | —         |       | 1,612              |       |
| Speculative one- to four-family construction |       | 884                   |       | —              |       | —         |       | —         |       | 884                |       |
| Multifamily residential                      |       | 3,915                 |       | —              |       | —         |       | —         |       | 3,915              |       |
| Land development                             |       | 1,181                 |       | —              |       | —         |       | —         |       | 1,181              |       |
| Land                                         |       | 8,589                 |       | —              |       | 16             |       | —         |       | 8,605              |       |
| Commercial real estate                       |       | 9,077                 |       | (57                 | )          | —         |       | —         |       | 9,020              |       |
| Commercial loans                             |       | 2,578                 |       | (67                 | )          | 1              |       | —         |       | 2,512              |       |
| Consumer loans                               |       | 560                   |       | (96                 | )          | 42             |       | 53             |       | 559                |       |
|                                         |       | $                     | 32,908     |                | $          | (379           | )          | $              | 70         |               | $          | 53 |   | $ | 32,652 |   |

 

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(1)          As noted in the table above,charge-offs for the three months ended March 31, 2010, were$379,000.  At March 31, 2010, specificvaluation allowances were $8.6 million. Due to the level of specific valuation allowances, we expect charge-offsto increase in future periods.

 

The composition of the allowance for loanlosses by component and category as of March 31, 2010 and December 31,2009 is presented below (in thousands):

 
| ** **                                   | ** ** | **March ****31, 2010**   | ** ** | **December 31, 2009**   | ** ** |
|----------------------------------------------|------------|------------------------------------|------------|-----------------------------------|------------|
| ** **                                   | ** ** | **Specific  Valuation  Allowance** | ** ** | **General  Valuation  Allowance** | ** ** | **GVA % of  Portfolio** | ** ** | **Specific  Valuation  Allowance** | ** ** | **General  Valuation  Allowance** | ** ** | **GVA % of  Portfolio** | ** ** |
| One- to four-family residential              |       | $                                  | 705        |                              | $          | 3,659 |   | 1.53 | % | $ | 405 |   | $ | 4,031 |   | 1.66 | % |
| Home equity and second mortgage              |       | 313                                |       | 1,299                             |       | 5.48 |   | 305 |   | 1,384 |   | 5.18 |   |
| Speculative one- to four-family construction |       | 123                                |       | 761                               |       | 11.13 |   | 120 |   | 764 |   | 8.75 |   |
| Multifamily residential                      |       | 1,206                              |       | 2,709                             |       | 7.38 |   | 547 |   | 3,368 |   | 8.09 |   |
| Land development                             |       | 55                                 |       | 1,126                             |       | 12.62 |   | 70 |   | 1,110 |   | 11.83 |   |
| Land                                         |       | 4,193                              |       | 4,412                             |       | 12.31 |   | 3,923 |   | 4,665 |   | 12.45 |   |
| Commercial real estate                       |       | 1,461                              |       | 7,559                             |       | 7.06 |   | 1,708 |   | 7,368 |   | 6.54 |   |
| Commercial loans                             |       | 459                                |       | 2,053                             |       | 15.92 |   | 291 |   | 2,286 |   | 16.00 |   |
| Consumer loans                               |       | 123                                |       | 436                               |       | 2.80 |   | 107 |   | 456 |   | 2.57 |   |
|                                         |       | $                                  | 8,638      |                              | $          | 24,014 |   | 4.93 | % | $ | 7,476 |   | $ | 25,432 |   | 4.97 | % |

 

Changes in the composition of the allowancefor loan losses between March 31, 2010 and December 31, 2009 arepresented in the following table (in thousands):

 
| ** ** | ** ** | **March 31,** | ** ** | **December 31,** | ** ** | **Increase**   | ** ** |
|------------|------------|--------------------|------------|-----------------------|------------|----------------|------------|
| ** ** | ** ** | **2010**           | ** ** | **2009**              | ** ** | **(Decrease)** | ** ** |
| General    |       | $                  | 24,014     |                  | $          | 25,432         |       | $ | (1,418 | ) |
| Specific   |       | 8,638              |       | 7,476                 |       | 1,162          |       |
|       |       | $                  | 32,652     |                  | $          | 32,908         |       | $ | (256 | ) |

 

The general component of the allowance forloan losses decreased primarily due to decreases in certain of the related loanbalances.  The specific component of theallowance for loan losses increased primarily due to allowances establishedsince December 31, 2009 on multifamily loans.  See “Asset Quality.”

 

The allowance for loan losses is establishedas losses are estimated to have occurred through a provision for loan lossescharged to earnings.  Loan losses arecharged against the allowance when management believes it is likely that a loanbalance is uncollectible.  Subsequentrecoveries, if any, are credited to the allowance.

 

The allowance for loan losses representsmanagement’s estimate of incurred credit losses inherent in the Company’s loanportfolio as of the balance sheet date. The estimation of the allowance is based on a variety of factors,including past loan loss experience, the current credit profile of theCompany’s borrowers, adverse situations that have occurred that may affect theborrowers’ ability to repay, the estimated value of underlying collateral, andgeneral economic conditions, including unemployment, bankruptcy trends, vacancyrates and home sales.  Losses arerecognized when available information indicates that it is probable that a losshas been incurred and the amount of the loss can be reasonably estimated. Thisevaluation is inherently subjective as it requires estimates that aresusceptible to significant revision as more information becomes available orconditions change.

 

A loan is considered impaired when, based oncurrent information and events, it is probable that the Bank will be unable tocollect the scheduled payments of principal or interest when due according tothe contractual terms of the loan agreement. Factors considered by managementin determining impairment include payment status, collateral

 

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value, and the probability of collecting scheduled principal andinterest payments when due. Loans that experience insignificant payment delaysand payment shortfalls generally are not classified as impaired. Managementdetermines the significance of payment delays and payment shortfalls on acase-by-case basis, taking into consideration all of the circumstancessurrounding the loan and the borrower, including the length of the delay, thereasons for the delay, the borrower’s prior payment record, and the amount ofthe short fall in relation to the principal and interest owed. Impairment ismeasured on a loan by loan basis by either the present value of expected futurecash flows discounted at the loan’s effective interest rate, the loan’sobtainable market price, or the fair value of the collateral if the loan iscollateral dependent.  Multifamilyresidential, commercial real estate, land and land development, and commercialloans that are delinquent or where the borrower’s total loan relationshipexceeds $1 million are evaluated on a loan-by-loan basis at least annually.

 

Large groups of smaller balance homogeneous loans are collectivelyevaluated for impairment. Accordingly, the Bank does not separately identifyindividual consumer 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 mortgage loans; (2) unsecured consumer loans;and (3) collateralized consumer loans to permit consideration of theappropriateness of the allowance for losses of each group of loans on a poolbasis. The primary methodology used to determine the appropriateness of theallowance for losses includes segregating certain specific, poorly performingloans based on their performance characteristics from the pools of loans as totype, valuing these loans, and then applying a loss factor to the remainingpool balance based on several factors including past loss experience, inherentrisks, and economic conditions in the primary market areas.

 

In estimating theamount of credit losses inherent in our loan portfolio, various judgments andassumptions are made.  For example, whenassessing the condition of the overall economic environment, assumptions aremade regarding market conditions and their impact on the loan portfolio.  For impaired loans that are collateraldependent, the estimated fair value of the collateral may deviate significantlyfrom the proceeds received when the collateral is sold in the event that theBank has to foreclose or repossess the collateral.

 

Although we consider theallowance for loan losses of approximately $32.6 million, which consists of ageneral valuation allowance of $24.0 million and a specific valuation allowanceof $8.6 million, adequate to cover losses inherent in our loan portfolio at March 31,2010, 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.  Either of these occurrences could materiallyand adversely affect our financial condition and results of operations.

 

**Investment Securities. **Changes in the compositionof investment securities held to maturity between March 31, 2010 and December 31, 2009 are presentedin the following table (in thousands).

 
| ** **                             | ** ** | **March 31****,** | ** ** | **December 31,** | ** ** | **Increase**   | ** ** |
|----------------------------------------|------------|------------------------|------------|-----------------------|------------|----------------|------------|
| ** **                             | ** ** | **2010**               | ** ** | **2009**              | ** ** | **(Decrease)** | ** ** |
| U.S. Government and agency obligations |       | $                      | 94,416     |                  | $          | 110,051        |       | $ | (15,635 | ) |
| Municipal securities                   |       | 24,846                 |       | 25,480                |       | (634           | )          |
| Total                                  |       | $                      | 119,262    |                  | $          | 135,531        |       | $ | (16,269 | ) |

 

During the first three months of 2010,investment securities totaling $16.3 million with an average tax equivalentyield of 5.27% matured or were called and no investments were purchased duringthe period.

 

At March 31, 2010, estimatedfair values of investment securities held to maturity were as follows (inthousands):

** **
| ** **                             | ** ** | **Amortized  Cost** | ** ** | **Fair  Value** | ** ** |
|----------------------------------------|------------|---------------------|------------|-----------------|------------|
|                                   |       |                |       |            |       |
| U.S. Government and agency obligations |       | $                   | 94,416     |            | $          | 93,848 |   |
| Municipal securities                   |       | 24,846              |       | 24,850          |       |
| Total                                  |       | $                   | 119,262    |            | $          | 118,698 |   |

 

**AccruedInterest Receivable. ** The decrease in accrued interestreceivable was primarily due to a decrease in the loans receivable balance anda decrease in the loan yield at March 31,2010 compared to December 31, 2009.

 

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**Real Estate Owned, net.**  Changesin the composition of real estate owned between March 31, 2010 and December 31, 2009 arepresented in the following table (dollars in thousands).

 
| ** **                      | ** ** | **December 31,  2009** | ** ** | **Additions** | ** ** | **Fair Value  Adjustments** | ** ** | **Net Sales  Proceeds(1)** | ** ** | **Loss** | ** ** | **March 31,  2010** | ** ** |
|---------------------------------|------------|-----------------------------|------------|---------------|------------|-----------------------------|------------|----------------------------|------------|----------|------------|--------------------------|------------|
| One- to four-family residential |       | $                           | 10,216     |          | $          | 3,208                       |       | $                          | (272       | )        | $          | (4,073                   | )          | $ | (3 | ) | $ | 9,076 |   |
| Speculative one- to four-family |       | 3,186                       |       | 200           |       | (127                        | )          | (164                       | )          | —   |       | 3,095                    |       |
| Multifamily                     |       | 545                         |       | —        |       | —                      |       | (126                       | )          | (42      | )          | 377                      |       |
| Land                            |       | 13,952                      |       | 180           |       | (100                        | )          | (244                       | )          | (6       | )          | 13,782                   |       |
| Commercial real estate          |       | 7,256                       |       | 117           |       | (80                         | )          | —                     |       | —   |       | 7,293                    |       |
|                            |       | $                           | 35,155     |          | $          | 3,705                       |       | $                          | (579       | )        | $          | (4,607                   | )          | $ | (51 | ) | $ | 33,623 |   |

 

----

(1)          Net sales proceeds include $2.9million of loans made by the Bank to facilitate the sale of real estate owned.

 

**Deposits. **Changes in the composition of depositsbetween March 31, 2010 and December 31, 2009 are presented in thefollowing table (dollars in thousands).

 
| ** **              | ** ** | **March 31,********2010** | ** ** | **December 31,  2009** | ** ** | **Increase  (Decrease)** | ** ** | **Percentage********Change** | ** ** |
|-------------------------|------------|--------------------------------|------------|-----------------------------|------------|--------------------------|------------|------------------------------|------------|
|                    |       |                           |       |                        |       |                     |       |                         |       |
| Checking accounts       |       | $                              | 136,776    |                        | $          | 166,707                  |       | $                            | (29,931    | ) | (18.0 | )% |
| Money Market accounts   |       | 49,729                         |       | 53,597                      |       | (3,868                   | )          | (7.2                         | )          |
| Savings accounts        |       | 26,850                         |       | 24,983                      |       | 1,867                    |       | 7.5                          |       |
| Certificates of deposit |       | 399,749                        |       | 379,337                     |       | 20,412                   |       | 5.4                          |       |
|                    |       |                           |       |                        |       |                     |       |                         |       |
| Total deposits          |       | $                              | 613,104    |                        | $          | 624,624                  |       | $                            | (11,520    | ) | (1.8 | )% |

 

Deposits decreased in the comparison period, primarily due to adecrease in public school checking accounts, offset by an increase incertificates of deposit. The Bankviews checking accounts as an attractive source of funds and will continue topromote such accounts as they offer overall low-interest deposits, fee incomepotential, and the opportunity to cross-sell other financial services.

 

**Other Borrowings.**  The Bank experienced a $24.0 million or 40.3%decrease in FHLB of Dallas borrowings during the quarter.  The FHLB of Dallas advances at March 31,2010 of $35.5 million consisted of $23.5 million of fixed rate advances with anaverage cost of 3.36% and $12.0 million of floating rate advances with anaverage cost of 0.37%.

 

**Stockholders’ Equity. **Stockholders’equity increased approximately $699,000 from December 31, 2009 to March 31,2010.  The increase in stockholders’equity was primarily due to net income of $905,000 during the first threemonths of 2010.  In addition, during the threemonths ended March 31, 2010, preferred dividends of approximately $206,000were accrued.  See the UnauditedCondensed Consolidated Statement of Stockholders’ Equity for the three monthsended March 31, 2010 for more detail.

 

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### **Average Balance Sheets**

### ** **

The following 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 March 31,** | ** ** |
|------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                       | ** ** | **2010**                              | ** ** | **2009** | ** ** |
| ** **                                                       | ** ** | **Average********Balance**            | ** ** | **Interest** | ** ** | **Average********Yield/********Cost** | ** ** | **Average********Balance** | ** ** | **Interest** | ** ** | **Average********Yield/********Cost** | ** ** |
| ** **                                                       | ** ** | **(Dollars in Thousands)**            | ** ** |
| Interest-earning assets:                                         |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| Loans receivable(1)                                              |       | $                                     | 499,334    |   | $ | 6,829 |   | 5.47 | % | $ | 567,745 |   | $ | 7,555 |   | 5.32 | % |
| Investment securities(2)                                         |       | 133,510                               |       | 1,587 |   | 4.76 |   | 126,240 |   | 1,564 |   | 4.96 |   |
| Other interest-earning assets                                    |       | 26,755                                |       | 15 |   | 0.23 |   | 14,740 |   | 3 |   | 0.10 |   |
| Total interest-earning assets                                    |       | 659,599                               |       | 8,431 |   | 5.11 |   | 708,725 |   | 9,122 |   | 5.15 |   |
| Noninterest-earning assets                                       |       | 70,308                                |       |   |   |   |   | 84,406 |   |   |   |   |   |
| Total assets                                                     |       | $                                     | 729,907    |   |   |   |   |   | $ | 793,131 |   |   |   |   |   |
| Interest-bearing liabilities:                                    |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| Deposits                                                         |       | $                                     | 617,274    |   | 2,549 |   | 1.65 |   | $ | 628,829 |   | 3,781 |   | 2.41 |   |
| Other borrowings                                                 |       | 64,016                                |       | 242 |   | 1.51 |   | 78,382 |   | 645 |   | 3.29 |   |
| Total interest-bearing liabilities                               |       | 681,290                               |       | 2,791 |   | 1.64 |   | 707,211 |   | 4,426 |   | 2.50 |   |
| Noninterest-bearing liabilities                                  |       | 4,750                                 |       |   |   |   |   | 7,822 |   |   |   |   |   |
| Total liabilities                                                |       | 686,040                               |       |   |   |   |   | 715,033 |   |   |   |   |   |
| Stockholders’ equity                                        |       | 43,867                                |       |   |   |   |   | 78,098 |   |   |   |   |   |
| Total liabilities and stockholders’ equity                  |       | $                                     | 729,907    |   |   |   |   |   | $ | 793,131 |   |   |   |   |   |
|                                                             |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| Net interest income                                              |       |                                  |       | $ | 5,640 |   |   |   |   |   | $ | 4,696 |   |   |   |
| Net earning assets                                               |       | $                                     | (21,691    | ) |   |   |   |   | $ | 1,514 |   |   |   |   |   |
| Interest rate spread                                             |       |                                  |       |   |   | 3.47 | % |   |   |   |   | 2.65 | % |
| Net interest margin                                              |       |                                  |       |   |   | 3.42 | % |   |   |   |   | 2.65 | % |
| Ratio of interest-earning assets to interest-bearing liabilities |       |                                  |       |   |   | 96.82 | % |   |   |   |   | 100.21 | % |

 

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(1)  Includes nonaccrual loans.

(2)  Includes FHLB of Dallasstock.

 

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## **Rate/Volume Analysis**

##  

The table below sets forth certaininformation regarding changes in interest income and interest expense of the Companyfor the periods indicated.  For eachcategory of interest-earning assets and interest-bearing liabilities,information is provided on changes attributable to (i) changes in volume(changes in average volume multiplied by prior rate); (ii) changes in rate(change in rate multiplied by prior average volume); (iii) changes inrate-volume (changes in rate multiplied by the change in average volume); and (iv) thenet change.

 
| ** **                         | ** ** | **Three Months Ended March 31,** | ** ** |
|------------------------------------|------------|---------------------------------------|------------|
| ** **                         | ** ** | **2010 vs. 2009**                     | ** ** |
| ** **                         | ** ** | **Increase (Decrease)**               | ** ** | ** ** | ** ** |
| ** **                         | ** ** | **Due to**                            | ** ** | **Total** | ** ** |
| ** **                         | ** ** | **Volume**                            | ** ** | **Rate** | ** ** | **Rate/********Volume** | ** ** | **Increase  (Decrease)** | ** ** |
| ** **                         | ** ** | **(In Thousands)**                    | ** ** |
| Interest income:                   |       |                                  |       |   |   |   |   |   |   |
| Loans receivable                   |       | $                                     | (910       | ) | $ | 209 |   | $ | (25 | ) | $ | (726 | ) |
| Investment securities              |       | 90                                    |       | (63 | ) | (4 | ) | 23 |   |
| Other interest-earning assets      |       | 3                                     |       | 5 |   | 4 |   | 12 |   |
| Total interest-earning assets      |       | (817                                  | )          | 151 |   | (25 | ) | (691 | ) |
|                               |       |                                  |       |   |   |   |   |   |   |
| Interest expense:                  |       |                                  |       |   |   |   |   |   |   |
| Deposits                           |       | (69                                   | )          | (1,184 | ) | 21 |   | (1,232 | ) |
| Other borrowings                   |       | (118                                  | )          | (349 | ) | 64 |   | (403 | ) |
| Total interest-bearing liabilities |       | (187                                  | )          | (1,533 | ) | 85 |   | (1,635 | ) |
| Net change in net interest income  |       | $                                     | (630       | ) | $ | 1,684 |   | $ | (110 | ) | $ | 944 |   |

 

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**CHANGES IN RESULTS OF OPERATIONS**

 

The table below presents acomparison of results of operations for the three months ended March 31,2010 and 2009 (dollars in thousands). Specific changes in captions are discussed in the sections which followthe table.

 
| ** **                                                           | ** ** | **Three Months Ended********March 31****,** | ** ** | **Increase********(Decrease)** | ** ** |
|----------------------------------------------------------------------|------------|--------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                           | ** ** | **2010**                                         | ** ** | **2009**                       | ** ** | **2010 vs 2009** | ** ** |
| Interest income:                                                     |       |                                             |       |                           |       |   |   |
| Loans receivable                                                     |       | $                                                | 6,829      |                           | $          | 7,555 |   | $ | (726 | ) |
| Investment securities                                                |       | 1,587                                            |       | 1,564                          |       | 23 |   |
| Other                                                                |       | 15                                               |       | 3                              |       | 12 |   |
| Total interest income                                                |       | 8,431                                            |       | 9,122                          |       | (691 | ) |
| Interest expense:                                                    |       |                                             |       |                           |       |   |   |
| Deposits                                                             |       | 2,549                                            |       | 3,781                          |       | (1,232 | ) |
| Other borrowings                                                     |       | 242                                              |       | 645                            |       | (403 | ) |
| Total interest expense                                               |       | 2,791                                            |       | 4,426                          |       | (1,635 | ) |
| Net interest income before provision for loan losses            |       | 5,640                                            |       | 4,696                          |       | 944 |   |
| Provision for loan losses                                            |       | 53                                               |       | 3,521                          |       | (3,468 | ) |
| Net interest income afterprovision for loan losses                   |       | 5,587                                            |       | 1,175                          |       | 4,412 |   |
| Noninterest income:                                                  |       |                                             |       |                           |       |   |   |
| Deposit fee income                                                   |       | 1,190                                            |       | 1,192                          |       | (2 | ) |
| Earnings on life insurance policies                                  |       | 198                                              |       | 197                            |       | 1 |   |
| Gain on sale of loans                                                |       | 136                                              |       | 148                            |       | (12 | ) |
| Other                                                                |       | 297                                              |       | 370                            |       | (73 | ) |
| Total noninterest income                                             |       | 1,821                                            |       | 1,907                          |       | (86 | ) |
| Noninterest expenses:                                                |       |                                             |       |                           |       |   |   |
| Salaries and employee benefits                                       |       | 2,798                                            |       | 2,967                          |       | (169 | ) |
| Real estate owned, net                                               |       | 801                                              |       | 395                            |       | 406 |   |
| FDIC insurance premium                                               |       | 515                                              |       | 241                            |       | 274 |   |
| Professional fees                                                    |       | 406                                              |       | 291                            |       | 115 |   |
| Advertising and public relations                                     |       | 64                                               |       | 111                            |       | (47 | ) |
| Other                                                                |       | 2,018                                            |       | 1,844                          |       | 174 |   |
| Total noninterest expenses                                           |       | 6,602                                            |       | 5,849                          |       | 753 |   |
| Income (loss) before income taxes                                    |       | 806                                              |       | (2,767                         | )          | 3,573 |   |
| Income tax benefit                                                   |       | (99                                              | )          | (1,264                         | )          | 1,165 |   |
| Net income (loss)                                                    |       | 905                                              |       | (1,503                         | )          | 2,408 |   |
| Preferred  stock dividends and accretion of preferred stock discount |       | 222                                              |       | 62                             |       | 160 |   |
| Net  income (loss) available to common shareholders                  |       | $                                                | 683        |                           | $          | (1,565 | ) | $ | 2,248 |   |
|                                                                 |       |                                             |       |                           |       |   |   |
| Basic earnings (loss) per common share                               |       | $                                                | 0.14       |                           | $          | (0.32 | ) | $ | 0.46 |   |
| Diluted earnings (loss) per common share                             |       | $                                                | 0.14       |                           | $          | (0.32 | ) | $ | 0.46 |   |
|                                                                 |       |                                             |       |                           |       |   |   |
| Interest rate spread                                                 |       | 3.47                                             | %          | 2.65                           | %          |   |   |
| Net interest margin                                                  |       | 3.42                                             | %          | 2.65                           | %          |   |   |
|                                                                 |       |                                             |       |                           |       |   |   |
| Average full-time equivalents                                        |       | 249                                              |       | 291                            |       |   |   |
|                                                                 |       |                                             |       |                           |       |   |   |
| Full-service offices                                                 |       | 20                                               |       | 20                             |       |   |   |

 

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**Net Interest Income. **Net interest income is determined by the Company’s interest rate spread(i.e., the difference between the yields earned on its interest-earning assetsand the rates paid on its interest-bearing liabilities) and the relativeamounts of interest-earning assets and interest-bearing liabilities.

 

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

### ** **

Dollar changes in interest income and interest expense for the comparisonperiods are presented in the Rate/Volume Analysis table which appears on aprevious page.

 

**Interest Income. **The decrease in interest income for the three month comparative periodwas primarily due to a decrease in the average balance of loans receivable.  The average balance of loans receivabledecreased due to repayments and maturities as well as a decrease in loanoriginations.

 

**Interest Expense.  **The decrease in interest expense for the three month comparative periodwas primarily due to a decrease in the average rates paid on deposits and otherborrowings as well as a decrease in the related average balances.  The decrease in the average rates paid on depositaccounts and other borrowings reflects decreases in market interest rates.

 

**Provision for Loan Losses.**  The provision for loan losses includescharges to maintain an allowance for loan losses adequate to cover probablecredit losses related to specifically identified loans as well as probablecredit losses inherent in the remainder of the loan portfolio that have beenincurred as of the balance sheet date. Such provision and the adequacy of the allowance for loan losses isevaluated quarterly by management of the Bank based on the Bank’s past loanloss experience, known and inherent risks in the portfolio, adverse situationsthat may affect the borrower’s ability to repay, the estimated value of anyunderlying collateral and current economic conditions.

 

The provision for loan losses decreased $3.5 million to $53,000 for thequarter ended March 31, 2010 compared to $3.5 million for the quarterended March 31, 2009.  During thefirst quarter of 2010, the loan portfolio held for investment shrank from$518.7 million to $495.6 million.  The$23.1 million decrease in the loan portfolio was primarily responsible for the$1.4 million decline in the general valuation allowance between December 31,2009 and March 31, 2010.  This wasoffset somewhat by a $1.2 million increase in specific valuation allowances,$600,000 of which was due to a multifamily residential construction loan.  See “Asset Quality.”

 

**NONINTERESTEXPENSE**

 

**Noninterestexpense. **Noninterest expenses are upoverall for the quarter ended March 31, 2010, compared to the same quarterin 2009, primarily due to the effects of the level of nonperforming loans andrelated collection costs, the level of real estate owned and related costs, andcosts incurred as a result of the Company Order and the Bank Order, asillustrated below.

 
| ** **               | ** ** | **Three Months Ended March 31,** | ** ** | ** ** | ** ** |
|--------------------------|------------|---------------------------------------|------------|------------|------------|
| ** **               | ** ** | **2010**                              | ** ** | **2009**   | ** ** | **Increase** | ** ** |
|                     |       |                                  |       |       |       |   |   |
| Real estate owned, net   |       | $                                     | 801        |       | $          | 395 |   | $ | 406 |   |
| FDIC insurance           |       | 515                                   |       | 241        |       | 274 |   |
| Supervisory assessments  |       | 106                                   |       | 48         |       | 58 |   |
| Professional fees        |       | 406                                   |       | 291        |       | 115 |   |
| Consultant fees          |       | 182                                   |       | 57         |       | 125 |   |
| Loan collection expenses |       | 157                                   |       | —     |       | 157 |   |
| Total                    |       | $                                     | 2,167      |       | $          | 1,032 |   | $ | 1,135 |   |

 

In order to offset the effects of the increased costs, the Company hasworked to control other costs where possible, as illustrated below.

 
| ** **                       | ** ** | **Three Months Ended March 31,** | ** ** | ** ** | ** ** |
|----------------------------------|------------|---------------------------------------|------------|------------|------------|
| ** **                       | ** ** | **2010**                              | ** ** | **2009**   | ** ** | **Decrease** | ** ** |
|                             |       |                                  |       |       |       |   |   |
| Salaries and employee benefits   |       | $                                     | 2,798      |       | $          | 2,967 |   | $ | (169 | ) |
| Occupancy expense                |       | 670                                   |       | 677        |       | (7 | ) |
| Data processing                  |       | 379                                   |       | 408        |       | (29 | ) |
| Advertising and public relations |       | 64                                    |       | 111        |       | (47 | ) |
| Postage and supplies             |       | 161                                   |       | 240        |       | (79 | ) |
| Other                            |       | 363                                   |       | 414        |       | (51 | ) |
| Total                            |       | $                                     | 4,435      |       | $          | 4,817 |   | $ | (382 | ) |

 

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**Salaries and Employee Benefits. **The changes in thecomposition of this line item are presented below (in thousands):

 
| ** **                        | ** ** | **Three Months Ended********March 31,** | ** ** | **Increase****(Decrease)** | ** ** |
|-----------------------------------|------------|----------------------------------------------|------------|----------------------------|------------|
| ** **                        | ** ** | **2010**                                     | ** ** | **2009**                   | ** ** | **2010 vs 2009** | ** ** |
| Salaries                          |       | $                                            | 2,293      |                       | $          | 2,467 |   | $ | (174 | ) |
| Payroll taxes                     |       | 206                                          |       | 230                        |       | (24 | ) |
| Insurance                         |       | 142                                          |       | 158                        |       | (16 | ) |
| 401(k)(1)                         |       | —                                       |       | 37                         |       | (37 | ) |
| Defined benefit plan contribution |       | 123                                          |       | 39                         |       | 84 |   |
| Other                             |       | 34                                           |       | 36                         |       | (2 | ) |
| Total                             |       | $                                            | 2,798      |                       | $          | 2,967 |   | $ | (169 | ) |

 

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

 

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

 

The Bank is a participant in the multiemployer Pentegra Defined BenefitPlan (the “Plan”).  The Plan isnon-contributory and covers all qualified employees. Since the Plan is amultiemployer plan, contributions of participating employers are commingled andinvested on a pooled basis without allocation to specific employers oremployees.  On April 30, 2010, theBoard of Directors of the Bank elected to freeze the Plan effective July 1,2010, eliminating all future benefit accruals for participants in the Plan andclosing the Plan to new participants as of that date. The Bank anticipatesannual cost savings from freezing the Plan of approximately $140,000. Actualcost savings will depend on a number of factors, including, but not limited to,administrative and other costs, the level of interest rates in the future andthe performance of Plan assets.  After July 1, 2010, the Bank willcontinue to incur costs consisting of administration and Pension BenefitGuaranty Corporation insurance expenses as well as amortization charges basedon the funding level of the Plan.  The level of amortization charges is determinedby the Plan’s funding shortfall, which is determined by comparing Planliabilities to Plan assets.  Based on current interest rates and Planassets, the Bank anticipates that the funding shortfall may increase, resultingin increased amortization charges effective July 1, 2010.  Increasedamortization charges will decrease cost savings associated with freezing thePlan.

 

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

 
| ** **               | ** ** | **Three Months Ended********March 31,** | ** ** | **Increase****(Decrease)** | ** ** |
|--------------------------|------------|----------------------------------------------|------------|----------------------------|------------|
| ** **               | ** ** | **2010**                                     | ** ** | **2009**                   | ** ** | **2010 vs 2009** | ** ** |
| Loss provisions          |       | $                                            | 579        |                       | $          | 164 |   | $ | 415 |   |
| Net loss (gain) on sales |       | 51                                           |       | (22                        | )          | 73 |   |
| Taxes and insurance      |       | 97                                           |       | 184                        |       | (87 | ) |
| Other                    |       | 74                                           |       | 69                         |       | 5 |   |
| Total                    |       | $                                            | 801        |                       | $          | 395 |   | $ | 406 |   |

 

Real estate owned is expected 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.

 

**FDIC Insurance Premium.**  FDIC insurance increased during the threemonth comparison period due to an increase in the premium rate for 2010.  FDIC premium expense is expected to continueto increase.  See “Part II, Item 1ARisk Factors — Future FDIC insurance premiums or special assessments may impactour earnings.”

 

**Professional Fees. **Professionalfees increased primarily due to an increase in audit fees and to a lesserdegree an increase in legal fees related to nonaccrual loans.  We expect professional fees to remain at anelevated level due to the amount of nonaccrual loans and the increased legal,accounting, and other fees associated with reporting and compliancerequirements.

 

**Advertising and Public Relations.**  The decrease in 2010 is primarily related toa decrease in direct mail, print media and broadcast media advertising.

 

**IncomeTaxes. **The income tax benefit decreased primarily due to theincrease in taxable income as well as the fact that there is a valuationallowance on the deferred tax asset as of March 31, 2010 and there was nosuch valuation allowance as of March 31, 2009.  See also Note 9 to the unaudited condensedconsolidated financial statements included in Part I, Item 1 herein forfurther information regarding income taxes.

 

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# **OFF-BALANCE SHEET ARRANGEMENTS**

# ** **

The Company, in the normal course ofbusiness, 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 March 31, 2010, theBank’s off-balance sheet arrangements principally included lending commitments,which are described below.  At March 31, 2010, the Company hadno interests in non-consolidated special purpose entities.

 

At March 31, 2010,commitments included:

 

·                  totalapproved commitments to originate or purchase loans amounting to $2.2 million;

·                  ratelock agreements with customers of $2.6 million, all of which have been locked with an investor;

·                  fundedmortgage loans committed to sell of $395,000;

·                  unadvancedportion of construction loans of $2.8 million;

·                  unusedlines of credit of $13.7 million;

·                  outstandingstandby letters of credit of approximately $3.5 million;

·                  totalpredetermined overdraft protection limits of $12.1 million; and

·                  certificatesof deposit scheduled to mature in one year or less totaling $252.2 million.

 

Total unfunded commitments to originate loans for sale and the relatedcommitments to sell of $2.6 million meet the definition of a derivativefinancial instrument.  The related asset andliability are considered immaterial at March 31, 2010.

 

Historically, a very small percentage of predetermined overdraft limitshave been used.  At March 31, 2010, overdrafts ofaccounts with Bounce ProtectionTM represented usage of 3.51% of the limit.  We expect utilization of these overdraftlimits to remain at comparable levels in the future.

 

Based on historical experience, management believes that a significantportion of maturing deposits will remain with the Bank.  We anticipate that we will continue to havesufficient funds, through repayments, deposits and borrowings, to meet ourcurrent commitments.

 

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### **LIQUIDITY AND CAPITAL RESOURCES**

### ** **

Liquidity management is both a dailyand long-term function of business management. The Bank’s liquidity,represented by cash and cash equivalents and eligible investment securities, isa product of its operating, investing and financing activities.  The Bank’s primary sources of funds aredeposits, borrowings, 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 investment securities are determined by the issuer andare generally influenced by the level of market interest rates at the bond’scall date compared to the coupon rate of the bond.  The Bank manages the pricing of its depositsto maintain deposit balances at levels commensurate with the operating,investing and financing activities of the Bank. In addition, the Bank invests excess funds in overnight deposits andother short-term interest-earning assets that provide liquidity to meet lendingrequirements and pay deposit withdrawals. When funds from the retail depositmarket are inadequate for the liquidity needs of the Bank or the pricing ofdeposits is not as favorable as other sources, the Bank has borrowed from theFHLB of Dallas.  Borrowings from the FRBdiscount window may currently be used only when other sources of liquidity arenot available to the Bank.

 

In April 2008, based on the FHLB rating criteria, the Bank wasnotified of the replacement of its FHLB blanket lien with a restricted custodycollateral arrangement, whereby the FHLB has custody and endorsement of theloans that collateralize the Bank’s outstanding borrowings with the FHLB. Qualifying loans (i) must not be 90 days or more past due; (ii) mustnot have been in default within the most recent twelve-month period, unlesssuch default has been cured in a manner acceptable to the FHLB; (iii) mustrelate to real property that is covered by fire and hazard insurance in anamount at least sufficient to discharge the mortgage loan in case of loss andas to which all real estate taxes are current; (iv) must not have beenclassified as substandard, doubtful, or loss by the Bank’s regulatory authorityor the Bank; and (v) must not secure the indebtedness to any director,officer, employee, attorney, or agent of the Bank or of any FHLB.  TheFHLB currently allows an aggregate collateral or lendable value on thequalifying loans of approximately 75% of the outstanding balance of the loanspledged to the FHLB.

 

During the first quarter of 2010, theuse of FHLB borrowings decreased by $24.0 million or 40.3%. At March 31,2010, the Bank’s borrowing capacity with FHLB was $81.6 million, comprised ofqualifying loans collateralized by first-lien one- to four-family mortgageswith a collateral value of $87.6 million and qualifying investment securitieswith a collateral value of $29.6 million less outstanding advances at March 31,2010 of $35.5 million.  The Bank may transfer additional eligible collateral to the FHLB toprovide additional borrowing capacity if needed.  Due to the Bank’s restricted status at theFHLB, the Bank may only borrow short-term FHLB advances with maturities up tothirty days.

 

The Bank was notified in December 2009by the FRB of various restrictions and collateral requirements.  The Bank is required to pledge collateralwith a value of $16 million to secure account transaction settlements.  This collateral may also be available toaccess the secondary discount window if unencumbered for transaction settlementand when other sources of funding are not available to the Bank. In addition,the Bank is required to maintain an account balance at the FRB to cover chargesto the Bank’s transaction account to avoid any daylight overdrafts.

 

The Bank uses qualifying investment securities and qualifyingcommercial real estate loans as collateral for the discount window and tosecure transactions settlements. In September 2008, a subordinationagreement was secured with the FHLB based on its blanket lien of commercialreal estate loans.  This agreementprovides the Bank the ability to pledge commercial real estate loans to the FRBdiscount window and to secure transaction settlements.  The loan collateral was held by the Bankthrough the FRB’s Borrower in Custody of Collateral Program until December 2009,when the FRB notified the Bank that custody must be transferred to the FRB.

 

TheFRB will not accept loans that: (i) are 30 days or more past due; (ii) areclassified as substandard, doubtful, or loss by the Bank’s regulating authorityor the Bank; (iii) are illegal investments for the Bank; (iv) secure theindebtedness to any director, officer, employee, attorney, affiliate or agentof the Bank; or that (v) exhibit collateral and credit documentationdeficiencies.  The lendable value ofcommercial real estate of approximately $16.8 million at March 31, 2010 was 57%of the fair market value of the loans as determined by the FRB taking intoconsideration the rate and duration of the loans pledged.  In addition, at March 31, 2010, the Bankpledged qualifying investment securities with a collateral value ofapproximately $3.3 million for the discount window and to secure transactionsettlements.

 

AtMarch 31, 2010, the Bank had short-term funds availability of approximately$169.4 million or 24.3% of assets consisting of borrowing capacity at the FHLBand the FRB, unpledged investment securities, and overnight funds including thebalances maintained at the FRB.  The Bankanticipates it will continue to rely primarily on deposits, calls of investmentsecurities, loan repayments, and funds provided from operations to provideliquidity.  As necessary, the sources ofborrowed funds described above will be used to augment the Bank’s other fundingsources.

 

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The Bank uses its sources of fundsprimarily to meet its ongoing commitments, to pay maturing savings certificatesand savings withdrawals, to repay maturing borrowings, to fund loan commitments,and to purchase investment securities. As of March 31, 2010, the Bank hadoutstanding commitments to originate loans of $2.2 million, including $682,000of loans committed to sell; unadvanced portion of construction loans of $2.8 million;and commitments to extend funds to, or on behalf of, customers pursuant tolines and letters of credit of $17.2 million. Scheduled maturities of certificates of deposit for the Bank during thetwelve months following March 31, 2010 amounted to $252.2 million.  Based on historical experience, managementbelieves that a significant portion of maturing deposits will remain with theBank.  Management anticipates the Bankwill continue to have sufficient funds, through loan repayments, deposits, andborrowings, to meet our current commitments. This expectation assumes that the FHLB will continue to extend creditbased on our borrowing capacity and that core deposits do not experience asubstantial decline.

 

The Bank emphasizes deposit growth andretention throughout our retail branch network to enhance our liquidityposition. Effective with the Bank Order in April 2010, the Bank mustcomply with federal restrictions on the interest rates we may offer to ourdepositors.  Under these restrictions, wemay pay up to 75 basis points over the national average rates set by the FDICfor each deposit product.  Although we donot believe these rate restrictions will have a significant impact on the levelof new and existing deposits, we cannot predict the impact on ourliquidity.  We have historically paidrates the middle of the market for regular term certificates of deposit andpaid above average rates locally for certificates of deposit with specialterms.

 

The Bank is participating in the FDIC’sTransaction Account Guarantee Program (“TAGP”) which fully insures noninterestbearing transaction deposit accounts, NOW accounts paying less than 0.5% perannum through June 30, 2010, when the threshold rate lowers to 0.25%, andInterest on Lawyers Trust Accounts, regardless of dollar amount. This program, originally set to expire onDecember 31, 2009 was extended to December 31, 2010.  An annualized 15 to 25 basis point assessmenton balances in qualifying accounts that exceed the existing deposit insurancelimit of $250,000 will be assessed on a quarterly basis.  The assessment rate will depend on theinstitution’s risk category.  At March 31, 2010, the Bank hadapproximately $4.1 million in transaction deposit accounts included in the TAGPwith $1.6 million in excess of $250,000 normal insurance coverage.

 

As of November 19, 2009 and inaccordance with the directive from the OTS, the Bank may no longer accept,renew or roll over brokered deposits without the written non-objection of theregional director of the OTS. The Bank has not relied on brokered deposits as aprimary source of funding.  As of March 31,2010 the Bank had $9.9 million or 2% of deposits in brokered deposits.  Approximately $4.4 million of the brokeredaccounts mature in 2010.  Based on thecurrent minimal level of brokered deposits, management does not anticipate thatthe restrictions imposed by the OTS on brokered deposits will have asignificant impact on the Bank’s liquidity position.

 

In the first quarter of 2010, management took additional steps tostrengthen the Bank’s liquidity position including the transfer of additionalcollateral in the form of qualifying one- to four-family loans to the FHLB ofDallas, a decrease in the Bank’s loan portfolio, establishment of a repurchaseagreement to utilize our investment portfolio for liquidity, and membership inan internet service in order to bid for non-brokered certificates of deposit asanother source of liquidity.

 

The Bank’s liquidity risk managementprogram assesses our current and projected funding needs to ensure thatsufficient funds or access to funds exist to meet those needs.  The program also includes effective methodsto achieve and maintain sufficient liquidity and to measure and monitorliquidity risk, including the preparation and submission of liquidity reportson a regular basis to the board of directors and to the OTS.  The program also contains a ContingencyFunding Plan that forecasts funding needs and funding sources under differentstress scenarios.  The ContingencyFunding Plan approved by the board of directors is designed to respond to anoverall decline in the economic environment, the banking industry or a problemspecific to our Bank.  A number ofdifferent contingency funding conditions may arise which may result in strainsor expectation of strains in the Bank’s normal funding activities includingcustomer reaction  to negative news ofthe banking industry, in general, or us, specifically.  As a result of negative news, some depositors may reduce the amount of deposits heldat the Bank if concerns persist, which could affect the level and compositionof the Bank’s deposit portfolio and thereby directly impact the Bank’sliquidity, funding costs and net interest margin. The Bank’s funding costs mayalso be adversely affected in the event that activities of the Federal ReserveBoard and the U.S. Department of the Treasury to provide liquidity for thebanking system and improvement in capital markets are curtailed or areunsuccessful. Such events could reduce liquidity in the markets, therebyincreasing funding costs to the Bank or reducing the availability of funds tothe Bank to finance its existing operations and thereby adversely affect theCompany’s results of operations, financial condition, future prospects,profitability, and stock price.

 

For 2009, the Company declareddividends of $0.01 per share in each of the first, second, and thirdquarters.  No dividend was declared forthe first quarter of 2010.  Futuredividend payments are subject to restrictions. See Part 1. Item 2 “Regulatory Enforcement Actions” for furtherinformation regarding dividend restrictions.

 

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Since the Companyis a holding company and does not conduct operations, its primary source ofliquidity is dividends from the Bank. The Company has no borrowings fromoutside sources.  The Company and theBank are currently not allowed to declare or pay dividends or make any othercapital distributions without the prior written approval of the OTS.  The Company suspended its common stockdividend in the fourth quarter of 2009 and deferred the payment of the dividendfor the quarter ended March 31, 2010 on its Fixed Rate Cumulative PerpetualPreferred Stock, Series A issued to the Treasury on March 6, 2009 as part ofthe Capital Purchase Program.  TheCompany funds its expenses from cash deposits maintained in the Bank and fromrepayments on the loan to the Bank subsidiary. The deposits in the Bank and theloan to the Bank amounted to $1.6 million at March 31, 2010.  Management believes the Company hassufficient resources to fund expenses throughout 2010.

 

At March 31, 2010,the Bank’s tangible, core and risk-based capital ratios amounted to 6.17%,6.17% and 10.64%, respectively, compared to OTS capital adequacy standards of1.5%, 4% and 8%.  Effective May 2009, theBank agreed with its primary regulator, the OTS, to maintain a core capitalratio of at least five percent and a risk-based capital ratio of at least tenpercent.  Further, the Bank Orderrequires the Bank to achieve and maintain a tier 1 core capital ratio and totalrisk-based capital ratio of 8% and 12%, respectively, by December 31,2010.  The Bank was not in compliancewith this requirement as of March 31, 2010.

 

### **FORWARD-LOOKING STATEMENTS**

### ** **

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

 

**Item 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK**

 

There has been nomaterial change in the market value of the Bank’s portfolio equity sinceDecember 31, 2009.  Similarly, whilethere has been no material change in the Company’s asset and liability positionsince such time, the Bank’s level of nonperforming assets continued to impactthe level of net interest income during the three months ended March 31,2010.  The Bank’s net interest margindecreased slightly from 3.49% for the three months ended December 31, 2009 to3.42% for the three months ended March 31, 2010. Based on the level ofnonperforming assets and competitive pressures on loan and deposit rates,management anticipates continued pressure on the Bank’s interest rate spreadand net interest margin for the second quarter of 2010, although maturingcertificates of deposit repricing to lower rates will somewhat offset thepressure on the interest rate spread and margin.

 

The ability tomaximize net interest income is largely dependent upon the achievement of apositive interest rate spread that can be sustained during fluctuations inprevailing interest rates.  Interest ratesensitivity is a measure of the difference between amounts of interest earningassets and interest bearing liabilities that either reprice or mature within agiven period of time.  The difference, orthe interest rate repricing “gap”, provides an indication of the extent towhich an institution’s interest rate spread will be affected by changes ininterest rates.  A gap is consideredpositive when the amount of interest rate-sensitive assets exceeds the amountof interest rate-sensitive liabilities, and is considered negative when theamount of interest rate-sensitive liabilities exceeds the amount of interestrate-sensitive assets.  Generally, duringa period of rising interest rates, a negative gap within shorter maturitieswould adversely affect net interest income, while a positive gap within shortermaturities would result in an increase in net interest income, and during aperiod of falling interest rates, a negative gap within shorter maturities wouldresult in an increase in net interest income while a positive gap withinshorter maturities would have the opposite effect.  Based on the Bank’s negative gap position, arising rate environment will negatively affect our interest rate spread and netinterest margin.

 

**Item 4.  CONTROLS AND PROCEDURES**

 

Our managementevaluated, with the participation of our Chief Executive Officer and ChiefFinancial Officer, the effectiveness of the design and operation of ourdisclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e)under the Securities Exchange Act of 1934) as of the end of the period coveredby this report.  Based on suchevaluation, our Chief Executive Officer and Chief Financial Officer haveconcluded that our disclosure controls and procedures are operatingeffectively.

 

No change in theCompany’s internal control over financial reporting (as defined in Rules13a-15(f) and 15d-15(f) under the Securities Exchange Act) occurred during themost recent fiscal quarter that has materially affected, or is reasonablylikely to materially affect, the Company’s internal control over financialreporting. 

 

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**Part II**

 

Item 1.                                 Legal Proceedings

 

Neither the Company nor the Bank is involved in anyother pending legal proceedings other than non-material legal proceedingsoccurring in the ordinary course of business.

 

Item 1A.                         Risk Factors

 

*You should carefully consider thefollowing risk factors, as well as other information in this Form 10-Q and theinformation contained in our other filings with the SEC.  You should carefully consider the followingrisks in light of our current operating environment and regulatory status. Theoccurrence of any of the events described below could materially adverselyaffect our liquidity, results of operations and financial condition and ourability to continue as a going concern. Additional risks not presently known byus or that we currently deem immaterial may also have a material adverseimpact.*

 

**The current economic environmentposes significant challenges for the Company and could continue to adverselyaffect its financial condition and results of operations.**

 

The Company is operating in a challenging anduncertain economic environment, including generally uncertain national andlocal conditions.  Financial institutionscontinue to be affected by sharp declines in the real estate market andconstrained financial markets.  Dramaticdeclines in the housing market over the past year, with falling home prices andincreasing foreclosures and unemployment, have resulted in significantwrite-downs of asset values by the Bank and other financial institutions.  Continued declines in real estate values,home sales volumes, and financial stress on borrowers as a result of theuncertain economic environment could continue to have an adverse effect on theBank’s borrowers or their customers, which could adversely affect the Company’sfinancial condition and results of operations. A worsening of these conditions would likely exacerbate the adverseeffects on the Company and others in the financial services industry.  For example, further deterioration in localeconomic conditions in the Company’s markets could drive losses beyond thatwhich is provided for in its allowance for loan losses.  The Company may also face the following risksin connection with these events:

 

·                  Economic conditions that negativelyaffect housing prices and the job market have resulted, and may continue toresult, in deterioration in credit quality of the Bank’s loan portfolio, andsuch deterioration in credit quality has had, and could continue to have, anegative impact on the Company’s business and financial condition.

·                  Market developments may affect consumerconfidence levels and may cause adverse changes in payment patterns, causingincreases in delinquencies and default rates on loans and other creditfacilities.

·                  The processes the Company uses toestimate the allowance for loan losses may no longer be reliable because theyrely on complex judgments, including forecasts of economic conditions, whichmay no longer be capable of accurate estimation.

·                  The Bank’s ability to assess thecreditworthiness of its customers may be impaired if the processes andapproaches it uses to select, manage, and underwrite its customers become lesspredictive of future charge-offs.

·                  The Company expects to face increasedregulation of its industry, and compliance with such regulation may increaseits costs, limit its ability to pursue business opportunities, and increasecompliance challenges.

 

As these conditions or similar ones continue to existor worsen, the Company could experience continuing or increased adverse effectson its financial condition and results of operations.

 

**Our failure to comply with applicableregulatory requirements and regulatory enforcement actions could result infurther restrictions and enforcement actions.**

 

The Bank is subject to supervision and regulation by theOTS.  As a federally chartered stocksavings and loan association, the Bank’s good standing with its regulators isof fundamental importance to the continuation of its business.  As more fully described in Part I, Item 2,“Regulatory Enforcement Actions”, on April 12, 2010, the Company and the Bankboth consented to the Orders issued by the OTS. The Orders require the Company and the Bank to, among other things, filewith the OTS an 

 

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updated business plan and capital plan and submit tothe OTS, on a quarterly basis with respect to the business plan and monthlywith respect to the capital plan, variance reports related to the plans.  The Order issued to the Bank alsosubstantially restricts the Bank’s lending activities.  We have incurred and expect to continue toincur significant additional regulatory compliance expense in connection withthe Orders, and we will incur ongoing expenses attributable to compliance withthe terms of the Orders.  In addition,the OTS must approve any deviation from our business plan, which could limitour ability to make any changes to our business, which could negatively impactthe scope and flexibility of our business activities.  We cannot predict the further impact of theOrders upon our business, financial condition or results of operations.

 

Any material failure by the Company and the Bank tocomply with the provisions of the Orders could result in further enforcementactions by the OTS. While the Company and the Bank intend to take such actionsas may be necessary to comply with the requirements of the Orders, there can beno assurance that the Company or the Bank will be able to comply fully with theOrders, or that efforts to comply with the Orders will not have adverse effectson the operations and financial condition of the Company or the Bank.

 

**Our capital levels currently are notsufficient to achieve compliance with the higher capital requirements we mustmeet by December 31, 2010.**

 

The Bank Order directs the Bank to raise its tier 1core capital and total risk-based capital ratios to 8% and 12%, respectively,by December 31, 2010.  At March 31, 2010,we did not meet these requirements and would have needed approximately $12.8million in additional capital based on assets at such date to meet theserequirements.  The Company currently doesnot have any capital available to invest in the Bank.  We are considering various strategies to helpus achieve these capital levels by December 31, 2010, but there is no assurancethat any capital raising strategy can be completed successfully by thatdate.  Moreover, any further increases toour allowance for loan losses and operating losses****would negatively impact our capital levels and make it moredifficult to achieve the capital levels directed by the OTS.  If we fail to meet the required capitallevels by December 31, 2010, the OTS could take additional enforcement actionagainst us, including the imposition of further operating restrictions.  The OTS also could direct us to seek a mergerpartner or to liquidate the Bank.

 

The decline in the Bank’s capital in 2009 as a result of the Company’sloss and the significant level of the Bank’s criticized assets were noted bythe Company’s independent registered public accounting firm as primary factorsin including an explanatory paragraph in their audit opinion for the year endedDecember 31, 2009, which expressed uncertainty about the Company’s ability tocontinue as a going concern.

 

**We have a high percentage ofnonperforming loans and classified assets relative to our total assets.  If our allowance for loan losses is notsufficient to cover our actual loan losses, our results of operations will beadversely affected.**

 

At March 31, 2010, our nonperforming loans totaled$46.6 million, representing 9.4% of total loans and 6.7% of total assets.  Further, loans classified by management assubstandard, including nonperforming loans, totaled $119.2 million,representing 24.6% of total loans and 17.1% of total assets.  At March 31, 2010, our allowance for loanlosses was $32.6 million, consisting of $24.0 million of general loan lossallowances and $8.6 million of specific valuation allowances.  The general valuation allowance represents51.6% of nonperforming loans.  In theevent our loan customers do not repay their loans according to their terms andthe collateral securing the payment of these loans is insufficient to pay anyremaining loan balance, we may experience significant loan losses, which couldhave a material adverse effect on our operating results.

 

Management maintains an allowance for loan lossesbased upon, among other things:

 

· historical experience;

· repayment capacity of borrowers;

· an evaluation of local, regional and nationaleconomic conditions;

· regular reviews of delinquencies and loan portfolioquality;

· collateral evaluations;

· current trends regarding the volume and severity ofproblem loans;

· the existence and effect of concentrations of credit;and

· results of regulatory examinations.

 

Based on those factors, management makes variousassumptions and judgments about the ultimate collectibility of the respectiveloan portfolios.  The determination ofthe appropriate level of the allowance for loan losses inherently involves ahigh degree of subjectivity and requires management to make significantestimates of current credit risks and future trends, all of which may undergomaterial changes. In addition, our board of directors and the OTS periodicallyreview our allowance for loan losses and may require an increase in theprovision for possible loan losses or the recognition of further loancharge-offs. The OTS’ judgments may differ from those of our management. The amountof future loan losses is susceptible to changes in economic, operating andother conditions, which may be 

 

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beyond our control, including changes in interestrates, and these losses may exceed current estimates. Federal regulatoryagencies, as an integral part of their examination process, review our loansand allowance for loan losses. The most recent OTS examination was completed inDecember 2009. While we believe that the allowance for loan losses is adequateto cover current losses, we cannot provide assurances that we will not need toincrease our allowance for loan losses or that regulators will not require anincrease in our allowance. Either of these occurrences could materially andadversely affect our financial condition and results of operations.

 

**Liquidity needs could adverselyaffect our results of operations and financial condition.**

 

The Bank’s primary sources of funds are deposits,maturing or called securities, and loan repayments. While scheduled loanrepayments are a relatively stable source of funds, they are subject to theability of borrowers to repay the loans. The ability of borrowers to repayloans can be adversely affected by a number of factors outside of our control,including changes in economic conditions, adverse trends or events affectingbusiness industry groups, reductions in real estate values or markets, businessclosings or lay-offs, inclement weather, natural disasters and internationalinstability. Additionally, deposit levels may be affected by a number offactors, including rates paid by competitors, general interest rate levels,returns available to customers on alternative investments, financial conditionor regulatory status of the Bank, actions by the OTS and general economicconditions. Accordingly, we may be required from time to time to rely onsecondary sources of liquidity to meet withdrawal demands or otherwise fund operations.Those sources may include Federal Home Loan Bank advances, repurchaseagreements and the Federal Reserve discount window.  Currently, however, the Bank may only borrowfrom the Federal Home Loan Bank on a short-term basis.

 

Our financial flexibility will be constrained if wecontinue to incur losses and are unable to maintain our access to funding or ifadequate financing is not available at acceptable interest rates. We may seekadditional debt in the future. Additional borrowings, if sought, may not beavailable to us or, if available, may not be available on reasonable terms. Ifadditional financing sources are unavailable, or are not available onreasonable terms, our financial condition, results of operations and futureprospects could be materially adversely affected. Finally, if we are requiredto rely more heavily on more expensive funding sources to support futuregrowth, our revenues may not increase proportionately to cover our costs. Inaddition, we may be required to slow or discontinue capital expenditures ormake other investments or liquidate assets should those sources not beadequate.

 

**There are increased risks involvedwith commercial real estate, construction, commercial business and consumerlending activities.**

 

Our loan portfolio includes loans secured by existingcommercial real estate.  In addition, ourportfolio includes loans for the construction of single-family residential realestate and land development loans. Commercial real estate and construction lending generally is consideredto involve a higher degree of risk than single-family residential lending dueto a variety of factors, including generally larger loan balances, thedependency on successful completion or operation of the project for repayment,the difficulties in estimating construction costs and loan terms which often donot require full amortization of the loan over its term and, instead, providefor a balloon payment at stated maturity. Our loan portfolio also includes commercial business loans to small- tomedium-sized businesses, which generally are secured by various equipment,machinery and other corporate assets, and a variety of consumer loans,including automobile loans, deposit account secured loans and unsecured loans.  Although commercial business loans andconsumer loans generally have shorter terms and higher interest rates thanmortgage loans, they generally involve more risk than mortgage loans because ofthe nature of, or in certain cases the absence of, the collateral which securessuch loans.  The Bank’s lendingactivities are currently restricted as a result of the Orders.  For a further discussion of the Orders, seePart I, Item 2, “Regulatory Enforcement Actions.”

 

**We may experience an ownership changewhich would result in a limitation of the use of our net operating losses.**

 

In general, under Section 382 of the Code, acorporation that undergoes an “ownership change” is subject to limitations onits ability to utilize its pre-change net operating losses (“NOLs”) to offsetfuture taxable income.  If we undergo anownership change in the future as a result of issuances of our common stock orotherwise, our ability to utilize NOLs could be further limited by Section 382of the Code.  In the event of anownership change, Section 382 imposes an annual limitation on the amount ofpost-ownership change taxable income a corporation may offset withpre-ownership change NOL carryforwards and certain recognized built-in losses.

 

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**We may issue additional shares of ourcommon stock in the future, which would dilute existing stockholder’s ownershipif they did not, or were not permitted to, invest in the additional issuances.**

 

The Bank has been directed by the OTS to raise itstier 1 core capital and total risk-based capital ratios to 8% and 12%,respectively, by December 31, 2010.  Hadthe Bank been required to meet these capital requirements at March 31, 2010, itwould have needed additional capital of approximately $12.8 million.  To meet these capital requirements and forother purposes, we expect to seek to raise capital during the third or fourthquarter of 2010.  Our ability to raiseadditional capital, if needed, will depend on conditions in the capital marketsat that time, which are outside our control, and on our financial condition andperformance.  Accordingly, we cannot makeassurances that we will be able to raise additional capital if needed on termsthat are acceptable to us, or at all.  Ifwe cannot raise additional capital when needed, the OTS could take additionalenforcement action against us, including the imposition of further operatingrestrictions.  The OTS also could directus to seek a merger partner or to liquidate the Bank.  Our certificate of incorporation makesavailable additional authorized shares of common stock and preferred stock forissuance from time to time at the discretion of our board of directors, withoutfurther action by the shareholders, except where shareholder approval isrequired by law or the Nasdaq Capital Market requirements.  The issuance of any additional shares ofcommon stock, preferred stock, or convertible securities could be substantiallydilutive to shareholders of our common stock. Holders of our shares of common stock have no preemptive rights thatentitle them to purchase their *pro rata*share of any offering of shares of any class or series and, therefore, ourshareholders may not be permitted to invest in future issuances of our commonstock and as a result will be diluted.

 

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

 

On May 22, 2009, the FDIC adopted a final rule levyinga five basis point special assessment on each insured depository institution’sassets minus Tier 1 capital as of June 30, 2009. We recorded an expense ofapproximately $350,000 during the quarter ended June 30, 2009, to reflect thespecial assessment. The final rule permitted the FDIC to levy up to twoadditional special assessments of up to five basis points each during 2009 ifthe FDIC estimated that the Deposit Insurance Fund reserve ratio will fall to alevel that the FDIC believes would adversely affect public confidence or to alevel that will be close to or below zero. No additional levies were assessedin 2009.  In addition, the FDIC increasedthe general assessment rate and, therefore, our FDIC general insurance premiumexpense will increase compared to prior periods.

 

On November 12, 2009, the FDIC adopted a final rulepursuant to which insured depository institutions will be required to prepaytheir estimated assessments for the fourth quarter of 2009, and for all of2010, 2011 and 2012. This pre-payment was due on December 30, 2009. Under therule, the assessment rate for the fourth quarter of 2009 and for 2010 is basedon each institution’s total base assessment rate for the third quarter of 2009,modified to assume that the assessment rate in effect on September 30, 2009 hadbeen in effect for the entire third quarter, and the assessment rate for 2011and 2012 would be equal to the modified third quarter assessment rate plus anadditional 3 basis points. In addition, each institution’s base assessment ratefor each period is calculated using its third quarter assessment base, adjustedquarterly for an estimated 5% annual growth rate in the assessment base throughthe end of 2012.  The Bank received anexemption from this prepayment requirement but will pay each quarterlyassessment as it becomes due.  The Bankreceived an exemption from this prepayment requirement due to its potentialimpact on the Bank’s liquidity position.

 

Recent insured institution failures, as well asdeterioration in banking and economic conditions, have significantly increasedthe loss provisions of the FDIC, resulting in a decline in the designatedreserve ratio to historical lows. The FDIC expects a higher rate of insuredinstitution failures in the next few years compared to recent years. Therefore,the reserve ratio may continue to decline. These developments have caused thepremiums assessed on us by the FDIC to increase and materially increase FDICinsurance expense. We are unable to predict the effect in future periods if theeconomic crisis continues.

 

**We are heavily regulated, and thatregulation could limit or restrict our activities and adversely affect ourearnings.**

 

We operate in a highly regulated industry and aresubject to examination, supervision, and comprehensive regulation by variousfederal and state agencies, including the OTS and the FDIC.  Our compliance with these regulations iscostly and may restrict some of our activities, including payment of dividends,mergers and acquisitions, investments, loans and interest rates and locationsof offices.

 

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In light of current conditions in the global financialmarkets and the global economy, regulators have increased their focus on theregulation of the financial services industry. Over the past year and a half,the U.S. financial regulators responding to directives of the ObamaAdministration and Congress have intervened on an unprecedented scale. Newlegislative proposals continue to be introduced in the U.S. Congress that couldfurther substantially increase regulation of the financial services industryand impose restrictions on the operations and general ability of firms withinthe industry to conduct business consistent with historical practices,including with respect to compensation, interest rates and the effect ofbankruptcy proceedings on consumer real property mortgages. Further, federaland state regulatory agencies may adopt changes to their regulations and/orchange the manner in which existing regulations are applied. We cannot predictthe substance or effect of pending or future legislation or regulation or theapplication of laws and regulation to us. Compliance with current and potentialregulation and scrutiny may significantly increase our costs, impede theefficiency of our internal business processes, require us to increase ourregulatory capital and limit our ability to pursue business opportunities in anefficient manner by requiring us to expend significant time, effort andresources to ensure compliance. Additionally, evolving regulations concerningexecutive compensation may impose limitations on us that affect our ability tocompete successfully for executive and management talent.

 

In addition, given the current economic and financialenvironment, our regulators may elect to alter standards or the interpretationof the standards used to measure regulatory compliance or to determine theadequacy of liquidity, certain risk management or other operational practicesfor financial services companies in a manner that impacts our ability toimplement our strategy and could affect us in substantial and unpredictableways and could have an adverse effect on our business, financial condition andresults of operations. Furthermore, the regulatory agencies have extremelybroad discretion in their interpretation of the regulations and laws and theirinterpretation of the quality of our loan portfolio, securities portfolio andother assets. If any regulatory agency’s assessment of the quality of ourassets differs from our assessment, we may be required to take additionalcharges that would have the effect of materially reducing our earnings, capitalratios and stock price.

 

In November 2009, the Federal Reserve Board issued afinal rule that, effective July 1, 2010, prohibits financial institutions fromcharging consumers fees for paying overdrafts on automated teller machine andone-time debit card transactions, unless a consumer consents, or opts in, to theoverdraft service for those types of transactions.  Consumers must be provided a notice thatexplains the financial institution’s overdraft services, including the feesassociated with the service, and the consumer’s choices.  Because the Company’s customers must provideadvance consent to the overdraft service for automated teller machine andone-time debit card transactions, the Company cannot provide any assurance asto the ultimate impact of this rule on the amount of overdraft/insufficientfunds charges reported in future periods.

 

**Changes in interest rates could havea material adverse effect on our operations.**

 

The operations of financial institutions such as theBank are dependent to a large extent on net interest income, which is thedifference between the interest income earned on interest earning assets suchas loans and investment securities and the interest expense paid on interestbearing liabilities such as deposits and borrowings.  Changes in the general level of interestrates can affect our net interest income by affecting the difference betweenthe weighted average yield earned on our interest earning assets and theweighted average rate paid on our interest bearing liabilities, or interestrate spread, and the average life of our interest earning assets and interestbearing liabilities.  Changes in interestrates also can affect our ability to originate loans; the value of our interestearning assets; our ability to obtain and retain deposits in competition withother available investment alternatives; and the ability of our borrowers torepay adjustable or variable rate loans. Interest rates are highly sensitive to many factors, includinggovernmental monetary policies, domestic and international economic andpolitical conditions and other factors beyond our control.  There can be no assurance that our results ofoperations would not be adversely affected during any period of changes ininterest rates due to a number of factors which can have a material impact onthe Bank’s interest rate risk position. Such factors include among other items, call features and interest ratecaps and floors on various assets and liabilities, prepayments, the currentinterest rates on assets and liabilities to be repriced in each period, and therelative changes in interest rates on different types of assets andliabilities.

 

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**The Company is subject torestrictions on its ability to declare or pay dividends and repurchase itsshares as a result of its participation in the Treasury’s Troubled Asset ReliefProgram Capital Purchase Program.  TheCompany and the Bank are prohibited from paying dividends or repurchasing commonstock.**

 

On March 6, 2009, the Company issued to the Treasuryfor aggregate consideration of $16.5 million (i) 16,500 shares of Series APreferred Stock and (ii) a Warrant to purchase 321,847 shares of the Company’sCommon Stock pursuant to the terms of the Purchase Agreement.  Under the terms of the Purchase Agreement,the Company’s ability to declare or pay dividends on any of its shares isrestricted.  Specifically, the Companymay not declare dividend payments on common, junior preferred or *pari passu* preferred shares if it is inarrears on the dividends on the Series A Preferred Stock.  In addition, the Company may not increase thedividends on its Common Stock above the amount of the last quarter cashdividend per share declared prior to October 14, 2008, which was $0.16 pershare, without the Treasury’s approval until the third anniversary of theinvestment unless all of the Series A Preferred Stock has been redeemed ortransferred.  The Company is currentlyrestricted from making or declaring any payments on its outstanding securities,including the dividends payable on the Series A Preferred Stock, without priorwritten non-objection from the OTS.  TheCompany deferred payment of the dividend on the Series A Preferred Stock in thefirst quarter of 2010.

 

The Company’s ability to repurchase its shares is alsorestricted under the terms of the Purchase Agreement.  The Treasury’s consent generally is requiredfor the Company to make any stock repurchases until the third anniversary ofthe investment by the Treasury unless all of the Series A Preferred Stock hasbeen redeemed or transferred.  Further,common, junior preferred or *pari passu*preferred shares may not be repurchased if the Company is in arrears on theSeries A Preferred Stock dividends. Under the Company Order, the Company may not repurchase shares of itscommon stock without the prior written non-objection of the OTS.

 

**We are subject to restrictions onexecutive compensation as a result of our participation in the CPP.**

 

Under the terms of the CPP, the U.S. Treasury hasimposed specified standards for executive compensation and corporate governancefor the period during which the U.S. Treasury holds any equity or warrantsissued pursuant to the CPP. These standards generally apply to our chief executiveofficer, chief financial officer, chief operating officer, and the two nextmost highly compensated senior executive officers. The standards include:

 

·                  ensuring that incentive compensation forsenior executives does not encourage unnecessary and excessive risks thatthreaten our value;

·                  required clawback of any bonus orincentive compensation paid to a senior executive based on statements ofearnings, gains or other criteria that are later proven to be materiallyinaccurate;

·                  prohibition on making golden parachutepayments to senior executives; and

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

 

Under the American Recovery and Reinvestment Act of2009 (the “ARRA”), further compensation restrictions, including significantlimitations on incentive compensation, have been imposed on our seniorexecutive officers and most highly compensated employees. Those restrictions,and any future restrictions on executive compensation that may be adopted,could adversely affect our ability to hire and retain senior executiveofficers.

 

**We may incur increased employeebenefit costs.**

 

The Bank is a participant in a non-contributorymultiemployer defined benefit pension plan covering all qualifiedemployees.  On April 30, 2010, the Boardof Directors of the Bank elected to freeze the plan effective July 1, 2010.  Freezing the plan eliminates all future benefitaccruals for participants in the plan and closes the plan to new participantsas of that date.  After July 1, 2010, theBank will continue to incur costs consisting of administration and PensionBenefit Guaranty Corporation insurance expenses as well as amortization chargesbased on the funding level of the plan. The level of amortization charges is determined by the plan’s fundingshortfall, which is determined by comparing plan liabilities to plan assets.  Based on current interest rates and plan assets,the Bank anticipates that the funding shortfall may increase, resulting inincreased amortization charges effective July 1, 2010.  Future pension funding requirements, and thetiming of funding payments, may be subject to changes in legislation.

 

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

 

We are subject to vigorous competition in all aspectsand areas of our business from banks and other financial institutions,including savings and loan associations, savings banks, finance companies,credit unions and other providers of financial services, such as money marketmutual funds, brokerage firms, consumer finance companies and insurancecompanies.  We also compete withnon-financial institutions, including retail stores that maintain their owncredit programs and governmental agencies that make available low cost orguaranteed loans to certain borrowers. Certain of our competitors are larger financial institutions withsubstantially greater resources, lending limits, larger branch systems and awider array of banking services. Competition from both bank and non-bank organizations will continue.

 

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

 

The banking industry is experiencing rapid changes intechnology.  In addition to improvingcustomer services, effective use of technology increases efficiency and enablesfinancial institutions to reduce costs. As a result, our future success will depend in part on our ability toaddress our customers’ needs by using technology.  We cannot assure that we will be able toeffectively develop new technology-driven products and services or besuccessful in marketing these products to our customers.  Many of our competitors have greaterresources than we have to invest in technology.

 

**We are subject to security andoperational risks relating to our use of technology that could damage ourreputation and our business.**

 

Security breaches in our internet banking activitiescould expose us to possible liability and damage our reputation. Any compromiseof our security also could deter customers from using our internet bankingservices that involve the transmission of confidential information. We rely onstandard internet security systems to provide the security and authenticationnecessary to effect secure transmission of data. These precautions may not protectour systems from compromises or breaches of our security measures that couldresult in damage to our reputation and our business. Additionally, we outsourceour data processing to a third party. If our third party provider encountersdifficulties or if we have difficulty in communicating with such third party,it could significantly affect our ability to adequately process and account forcustomer transactions, which could significantly affect our businessoperations.  The Bank has never incurreda material security breach nor encountered any significant down time with ouroutsourced partners.

 

Item 2.                                   Unregistered Sales of Equity Securitiesand Use of Proceeds

 

The Company did not repurchase any securities duringthe first quarter of 2010.  The Company isin its 19th announced repurchase program, which was approved by the board ofdirectors 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 March 31,2010.  All treasury stock purchases aremade under publicly announced repurchase programs.  The repurchase program is currentlysuspended.  The Company Order prohibitsthe Company from repurchasing shares of its common stock without the priorwritten non-objection of the OTS.

 

Item 3.                                   Defaults Upon Senior Securities

 

Not applicable.

 

Item 4.                                     Removed and reserved.

 

Item 5.                                   Other Information

 

None.

 

Item 6.                                   Exhibits

 

Exhibit 31.1 — Certification of Chief ExecutiveOfficer,

Pursuant to Section 302 of the Sarbanes-Oxley Act of2002 (18 U.S.C. 1350)

Exhibit 31.2 — Certification of Chief FinancialOfficer,

Pursuant to Section 302 of the Sarbanes-Oxley Act of2002 (18 U.S.C. 1350)

Exhibit 32.1 — Certification of Chief ExecutiveOfficer,

Pursuant to Section 906 of the Sarbanes-Oxley Act of2002 (18 U.S.C. 1350)

Exhibit 32.2 — Certification of Chief FinancialOfficer,

Pursuant to Section 906 of the Sarbanes-Oxley Act of2002 (18 U.S.C. 1350)

 

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**SIGNATURES**

 

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

 
|                            | **FIRST FEDERAL BANCSHARES OF ARKANSAS, INC.** |
|---------------------------------|------------------------------------------------|
|                            |                                           |   |
|                            |                                           |   |
| Date:   May  17, 2010 | By:                                            | /s/ Larry J. Brandt |
|                            |                                           | Larry J. Brandt |
|                            |                                           | Chief Executive Officer |
|                            |                                           |   |
|                            |                                           |   |
| Date:   May  17, 2010 | By:                                            | /s/ Sherri R. Billings |
|                            |                                           | Sherri R. Billings |
|                            |                                           | Chief Financial Officer and Chief Accounting Officer |
|                                 |                                                |  |  |

 

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