**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, DC 20549**

**Form 10-Q**

** **
| **(Mark One)**                                         | ** **                                                                                              |
|--------------------------------------------------------|---------------------------------------------------------------------------------------------------------|
| x                                                      | **QUARTERLY REPORT PURSUANT TO SECTION 13  OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|                                                   | ** **                                                                                              |
| **For the quarterly period ended  June 30, 2006** |
| ** **                                             | ** **                                                                                              |
| o                                                      | **TRANSITION REPORT PURSUANT TO SECTION 13  OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

**Commission file number 033-19694**

**FirstCityFinancial Corporation**(Exact name of registrantas specified in its charter)

* *
| **Delaware**                             | **76-0243729**       |
|------------------------------------------|----------------------|
| (State or other jurisdiction of          | (I.R.S.  Employer    |
| incorporation or organization)           | Identification  No.) |
| ** **                               |                 |
| **6400 Imperial Drive,**                 |                 |
| **Waco, TX**                             | **76712**            |
| (Address of principal executive offices) | (Zip  Code)          |

**(254) 761-2800**(Registrant’s telephonenumber, including area code)

Indicateby check mark whether the registrant: (1) has filed all reports requiredto be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes x     No o

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2of the Exchange Act.  (Check one.)

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

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

Thenumber of shares of common stock, par value $.01 per share, outstanding at August 9,2006 was 11,314,437.

 

----

**TABLE OF CONTENTS**
| PART I                                                                                              |
|-----------------------------------------------------------------------------------------------------|
| Item 1. Financial Statements                                                                        |
| Item 2. Management’s Discussion and Analysis of  Financial Condition and Results of Operations |
| Item 3. Quantitative and Qualitative Disclosures About  Market Risk                                 |
| Item 4. Controls and Procedures                                                                     |
| PART II                                                                                             |
| OTHER  INFORMATION                                                                                  |
| Item 1. Legal Proceedings                                                                           |
| Item 1A. Risk Factors                                                                               |
| Item 2. Unregistered Sales of Equity Securities and  Use of Proceeds                                |
| Item 3. Defaults Upon Senior Securities                                                             |
| Item 4. Submission of Matters to a Vote of Security  Holders                                        |
| Item 5. Other Information                                                                           |
| Item 6. Exhibits                                                                                    |
| SIGNATURES                                                                                          |
| Exhibit  Index                                                                                      |
| Certification of CEO Pursuant  to Section 302                                                       |
| Certification of CFO Pursuant  to Section 302                                                       |
| Certification of CEO Pursuant  to Section 906                                                       |
| Certification of CFO Pursuant  to Section 906                                                       |

 

----

** **

Table of Contents

**PART I**

**FINANCIAL INFORMATION**

**Item 1. Financial Statements.**

**FIRSTCITYFINANCIAL CORPORATION AND SUBSIDIARIES**

 

**CONSOLIDATEDBALANCE SHEETS**

**(Dollarsin thousands, except per share data)**

** **
| ** **                                                                                                                                       | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                       | ** ** | **2006**          | ** ** | **2005**              | ** ** |
| ** **                                                                                                                                       | ** ** | **(Unaudited)**   | ** ** | ** **            | ** ** |
| **ASSETS**                                                                                                                                       | ** ** | ** **        | ** ** | ** **            | ** ** |
| Cash and cash  equivalents                                                                                                                       |       | $                 | 10,312     |                  | $          | 12,901 |   |
| Portfolio Assets, net                                                                                                                            |       | 58,005            |       | 49,346                |       |
| Loans receivable from  Acquisition Partnerships held for investment                                                                              |       | 25,789            |       | 19,606                |       |
| Equity investments                                                                                                                               |       | 67,999            |       | 83,785                |       |
| Deferred tax asset, net                                                                                                                          |       | 20,101            |       | 20,101                |       |
| Service fees receivable  from affiliates                                                                                                         |       | 1,227             |       | 1,103                 |       |
| Other assets, net                                                                                                                                |       | 7,078             |       | 7,870                 |       |
| Discontinued mortgage  assets                                                                                                                    |       | 100               |       | 157                   |       |
| Total Assets                                                                                                                                     |       | $                 | 190,611    |                  | $          | 194,869 |   |
|                                                                                                                                             |       |              |       |                  |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                   | ** ** | ** **        | ** ** | ** **            | ** ** |
| Liabilities:                                                                                                                                     |       |              |       |                  |       |
| Notes payable  other                                                                                                                             |       | $                 | 81,658     |                  | $          | 89,653 |   |
| Notes payable to  affiliates                                                                                                                     |       | 474               |       | 606                   |       |
| Minority  interest                                                                                                                               |       | 2,082             |       | 1,193                 |       |
| Liabilities from  discontinued consumer operations                                                                                               |       | 127               |       | 121                   |       |
| Other  liabilities                                                                                                                               |       | 3,373             |       | 4,385                 |       |
| Total  Liabilities                                                                                                                               |       | 87,714            |       | 95,958                |       |
| Commitments and  contingencies (note 11)                                                                                                         |       |              |       |                  |       |
| Stockholders’ equity:                                                                                                                       |       |              |       |                  |       |
| Optional  preferred stock (par value $.01 per share; 98,000,000 shares authorized; no  shares issued or outstanding)                             |       | —            |       | —                |       |
| Common stock  (par value $.01 per share; 100,000,000 shares authorized; shares issued and outstanding:  11,309,437 and 11,307,187, respectively) |       | 113               |       | 113                   |       |
| Paid in capital                                                                                                                                  |       | 100,094           |       | 99,843                |       |
| Retained earnings (accumulated  deficit)                                                                                                         |       | 1,227             |       | (2,058                | )          |
| Accumulated  other comprehensive income                                                                                                          |       | 1,463             |       | 1,013                 |       |
| Total  Stockholders’ Equity                                                                                                                 |       | 102,897           |       | 98,911                |       |
| Total Liabilities and  Stockholders’ Equity                                                                                                 |       | $                 | 190,611    |                  | $          | 194,869 |   |

See accompanying notes to consolidated financial statements.

2

----

** **

Table of Contents

**FIRSTCITYFINANCIAL CORPORATION AND SUBSIDIARIES**

 

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(Inthousands, except per share data)**

**(Unaudited)**

 
| ** **                                                                     | ** ** | **Three Months Ended**                         | ** ** | **Six Months Ended**                           | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                                     | ** ** | **June 30,**                                        | ** ** | **June 30,**                                        | ** ** |
| ** **                                                                     | ** ** | **    2006    ** | ** ** | **    2005    ** | ** ** | **    2006    ** | ** ** | **    2005    ** | ** ** |
| Revenues:                                                                      |       |                                                     |       |                                                     |       |   |   |   |   |
| Servicing fees from affiliates                                                 |       | $                                                        | 2,856      |                                                     | $          | 2,909 |   | $ | 5,503 |   | $ | 6,081 |   |
| Income from Portfolio Assets                                                   |       | 2,946                                                    |       | 1,805                                                    |       | 5,004 |   | 4,145 |   |
| Interest income from affiliates                                                |       | 465                                                      |       | 449                                                      |       | 895 |   | 873 |   |
| Other income                                                                   |       | 639                                                      |       | 426                                                      |       | 1,219 |   | 810 |   |
| Total revenues                                                                 |       | 6,906                                                    |       | 5,589                                                    |       | 12,621 |   | 11,909 |   |
|                                                                           |       |                                                     |       |                                                     |       |   |   |   |   |
| Expenses:                                                                      |       |                                                     |       |                                                     |       |   |   |   |   |
| Interest and fees on notes payable — other                                |       | 1,938                                                    |       | 838                                                      |       | 3,636 |   | 1,710 |   |
| Interest and fees on notes payable to affiliates                               |       | 10                                                       |       | 10                                                       |       | 20 |   | 18 |   |
| Salaries and benefits                                                          |       | 3,278                                                    |       | 3,684                                                    |       | 7,016 |   | 7,842 |   |
| Provision (recovery) for loan and impairment losses                            |       | (58                                                      | )          | 29                                                       |       | 51 |   | 114 |   |
| Occupancy, data processing, communication and other                            |       | 1,913                                                    |       | 1,753                                                    |       | 3,477 |   | 3,666 |   |
| Total expenses                                                                 |       | 7,081                                                    |       | 6,314                                                    |       | 14,200 |   | 13,350 |   |
| Equity in  earnings of investments                                             |       | 1,387                                                    |       | 3,690                                                    |       | 5,021 |   | 7,091 |   |
| Earnings from  continuing operations before income taxes and minority interest |       | 1,212                                                    |       | 2,965                                                    |       | 3,442 |   | 5,650 |   |
| Income tax expense                                                             |       | (22                                                      | )          | (103                                                     | )          | (144 | ) | (242 | ) |
| Minority interest                                                              |       | 73                                                       |       | (42                                                      | )          | 62 |   | (39 | ) |
| Earnings from  continuing operations                                           |       | 1,263                                                    |       | 2,820                                                    |       | 3,360 |   | 5,369 |   |
| Discontinued  operations                                                       |       |                                                     |       |                                                     |       |   |   |   |   |
| Loss from discontinued operations                                              |       | —                                                   |       | (97                                                      | )          | (75 | ) | (97 | ) |
| Income taxes                                                                   |       | —                                                   |       | —                                                   |       | — |   | — |   |
| Net loss from discontinued operations                                          |       | —                                                   |       | (97                                                      | )          | (75 | ) | (97 | ) |
| Net earnings                                                                   |       | $                                                        | 1,263      |                                                     | $          | 2,723 |   | $ | 3,285 |   | $ | 5,272 |   |
| Basic earnings  per common share are as follows:                               |       |                                                     |       |                                                     |       |   |   |   |   |
| Earnings from continuing operations                                            |       | $                                                        | 0.11       |                                                     | $          | 0.25 |   | $ | 0.30 |   | $ | 0.48 |   |
| Discontinued operations                                                        |       | $                                                        | —     |                                                     | $          | (0.01 | ) | $ | (0.01 | ) | $ | (0.01 | ) |
| Net earnings to common stockholders                                            |       | $                                                        | 0.11       |                                                     | $          | 0.24 |   | $ | 0.29 |   | $ | 0.47 |   |
| Weighted average common shares outstanding                                     |       | 11,308                                                   |       | 11,274                                                   |       | 11,308 |   | 11,268 |   |
| Diluted earnings  per common share are as follows:                             |       |                                                     |       |                                                     |       |   |   |   |   |
| Earnings from continuing operations                                            |       | $                                                        | 0.11       |                                                     | $          | 0.24 |   | $ | 0.28 |   | $ | 0.45 |   |
| Discontinued operations                                                        |       | $                                                        | —     |                                                     | $          | (0.01 | ) | $ | (0.01 | ) | $ | (0.01 | ) |
| Net earnings to common stockholders                                            |       | $                                                        | 0.11       |                                                     | $          | 0.23 |   | $ | 0.27 |   | $ | 0.44 |   |
| Weighted average  common shares outstanding                                    |       | 11,959                                                   |       | 12,025                                                   |       | 11,958 |   | 12,016 |   |

See accompanying notes to consolidated financial statements.

3

----

** **

Table of Contents

**FIRSTCITYFINANCIAL CORPORATION AND SUBSIDIARIES**

 

**CONSOLIDATEDSTATEMENTS OF STOCKHOLDERS’ EQUITY**

**ANDCOMPREHENSIVE INCOME**

**(Dollarsin thousands)**

** **
| ** **                                                                 | ** ** | ** **         | ** ** | ** ** | ** ** | ** **       | ** ** | **Retained**     | ** ** | **Accumulated**   | ** ** | ** **             | ** ** |
|----------------------------------------------------------------------------|------------|--------------------|------------|------------|------------|------------------|------------|------------------|------------|-------------------|------------|------------------------|------------|
| ** **                                                                 | ** ** | **Number of** | ** ** | ** ** | ** ** | ** **       | ** ** | **Earnings**     | ** ** | **Other**         | ** ** | **Total**              | ** ** |
| ** **                                                                 | ** ** | **Common**         | ** ** | **Common** | ** ** | **Paid in** | ** ** | **(Accumulated** | ** ** | **Comprehensive** | ** ** | **Stockholders’** | ** ** |
| ** **                                                                 | ** ** | **Shares**         | ** ** | **Stock**  | ** ** | **Capital**      | ** ** | **Deficit)**     | ** ** | **Income**        | ** ** | **Equity**             | ** ** |
| ** **                                                                 | ** ** | ** **         | ** ** | ** ** | ** ** | ** **       | ** ** | ** **       | ** ** | ** **        | ** ** | ** **             | ** ** |
| **Balances,  December 31, 2004**                                      |       | 11,260,687         |       | $          | 113        |             | $          | 99,364           |       | $                 | (10,289    | )                      | $          | 3,235 |   | $ | 92,423 |   |
| Exercise of  common stock options                                          |       | 46,500             |       | —     |       | 196              |       | —           |       | —            |       | 196                    |       |
| Additional  paid-in capital arising from sale of shares by investee        |       | —             |       | —     |       | 283              |       | —           |       | —            |       | 283                    |       |
| Comprehensive  income:                                                     |       |               |       |       |       |             |       |             |       |              |       |                   |       |
| Net earnings for 2005                                                      |       | —             |       | —     |       | —           |       | 8,231            |       | —            |       | 8,231                  |       |
| Translation adjustments                                                    |       | —             |       | —     |       | —           |       | —           |       | (2,222            | )          | (2,222                 | )          |
| Total  comprehensive income                                                |       |               |       |       |       |             |       |             |       |              |       | 6,009                  |       |
| **Balances,  December 31, 2005**                                      |       | 11,307,187         |       | 113        |       | 99,843           |       | (2,058           | )          | 1,013             |       | 98,911                 |       |
| Exercise of  common stock options                                          |       | 2,250              |       | —     |       | 5                |       | —           |       | —            |       | 5                      |       |
| Additional  paid-in capital arising from stock option compensation expense |       | —             |       | —     |       | 246              |       | —           |       | —            |       | 246                    |       |
| Comprehensive  income:                                                     |       |               |       |       |       |             |       |             |       |              |       |                   |       |
| Net earnings for the first six months of 2006                              |       | —             |       | —     |       | —           |       | 3,285            |       | —            |       | 3,285                  |       |
| Translation adjustments                                                    |       | —             |       | —     |       | —           |       | —           |       | 450               |       | 450                    |       |
| Total  comprehensive income                                                |       |               |       |       |       |             |       |             |       |              |       | 3,735                  |       |
| **Balances, June 30, 2006  (unaudited)**                              |       | 11,309,437         |       | $          | 113        |             | $          | 100,094          |       | $                 | 1,227      |                   | $          | 1,463 |   | $ | 102,897 |   |

See accompanying notes to consolidated financial statements.

4

----

** **

Table of Contents

**FIRSTCITYFINANCIAL CORPORATION AND SUBSIDIARIES**

 

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Dollarsin thousands)**

**(Unaudited)**

 

** **

 
| ** **                                                                       | ** ** | **Six Months Ended**                                       | ** ** |
|----------------------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                                                       | ** ** | **June 30,**                                                    | ** ** |
| ** **                                                                       | ** ** | **     2006     ** | ** ** | **     2005     ** | ** ** |
| Cash flows from  operating activities:                                           |       |                                                                 |       |   |   |
| Net earnings                                                                     |       | $                                                                    | 3,285      |   | $ | 5,272 |   |
| Adjustments to reconcile net earnings to net cash  used in operating activities: |       |                                                                 |       |   |   |
| Net loss from discontinued operations                                            |       | 75                                                                   |       | 97 |   |
| Purchase and advances of Portfolio Assets and loans  receivable, net             |       | (32,924                                                              | )          | (15,883 | ) |
| Proceeds applied to principal on Portfolio Assets  and loans receivable          |       | 23,333                                                               |       | 15,518 |   |
| Income from Portfolio Assets                                                     |       | (5,004                                                               | )          | (4,145 | ) |
| Capitalized interest and costs on Portfolio Assets  and loans receivable         |       | (246                                                                 | )          | (155 | ) |
| Provision for loan and impairment losses                                         |       | 51                                                                   |       | 114 |   |
| Equity in earnings of investments                                                |       | (5,021                                                               | )          | (7,091 | ) |
| Depreciation and amortization                                                    |       | 274                                                                  |       | 461 |   |
| Stock-based compensation expense related to stock  options                       |       | 246                                                                  |       | — |   |
| (Increase) decrease in service fees receivable from  affiliate                   |       | (124                                                                 | )          | 399 |   |
| Decrease in other assets                                                         |       | 139                                                                  |       | 405 |   |
| Change in debt imputed value                                                     |       | (129                                                                 | )          | 58 |   |
| Decrease in other liabilities                                                    |       | (712                                                                 | )          | (2,022 | ) |
| Net cash used in operating activities                                            |       | (16,757                                                              | )          | (6,972 | ) |
| Cash flows from  investing activities:                                           |       |                                                                 |       |   |   |
| Property and equipment, net                                                      |       | (115                                                                 | )          | (82 | ) |
| Contributions to Acquisition Partnerships and  Servicing Entities                |       | (21,518                                                              | )          | (3,752 | ) |
| Distributions from Acquisition Partnerships and  Servicing Entities              |       | 44,937                                                               |       | 13,292 |   |
| Net cash provided by investing activities                                        |       | 23,304                                                               |       | 9,458 |   |
| Cash flows from  financing activities:                                           |       |                                                                 |       |   |   |
| Borrowings under notes payable — other                                      |       | 57,265                                                               |       | 29,532 |   |
| Payments of notes payable to affiliates                                          |       | (3                                                                   | )          | (4 | ) |
| Payments of notes payable — other                                           |       | (66,386                                                              | )          | (29,734 | ) |
| Proceeds from issuance of common stock                                           |       | 5                                                                    |       | 118 |   |
| Net cash used in financing activities                                            |       | (9,119                                                               | )          | (88 | ) |
| Net cash provided by (used in) continuing operations                             |       | (2,572                                                               | )          | 2,398 |   |
| Cash flows from  discontinued operations (Revised - see note 1):                 |       |                                                                 |       |   |   |
| Net cash used in operating activities                                            |       | (17                                                                  | )          | (8,115 | ) |
| Net cash provided by investing activities                                        |       | —                                                               |       | 1,330 |   |
| Net cash used in discontinued operations                                         |       | (17                                                                  | )          | (6,785 | ) |
| Net decrease in  cash and cash equivalents                                       |       | (2,589                                                               | )          | (4,387 | ) |
| Cash and cash equivalents,  beginning of period                                  |       | 12,901                                                               |       | 9,724 |   |
| Cash and cash  equivalents, end of period                                        |       | $                                                                    | 10,312     |   | $ | 5,337 |   |
| Supplemental  disclosure of cash flow information:                               |       |                                                                 |       |   |   |
| Cash paid during the period for:                                                 |       |                                                                 | ** ** | ** ** | ** ** |
| Interest                                                                         |       | $                                                                    | 3,144      |   | $ | 1,276 |   |
| Income taxes,  net of refunds received                                           |       | (34                                                                  | )          | 213 |   |

See accompanying notes to consolidated financial statements.

5

----

** **

Table of Contents

**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTSJune 30, 2006(Dollars in thousands, except per share data)(Unaudited)**

**(1)  Basis of Presentation and Summary ofSignificant Accounting Policies**

***The Company***

FirstCityFinancial Corporation (the “Company” or “FirstCity”) is a financial servicescompany with offices throughout the United States and Mexico, with a presencein France, Germany and South America. At June 30, 2006, the Company was engagedin one principal reportable segment - Portfolio Asset acquisition andresolution.  The portfolio asset acquisition and resolution business involvesacquiring portfolios of loans, real estate and other assets or single assets(collectively referred to as “Portfolios” or “Portfolio Assets”) at a discount to their legal principalbalance or appraised value, and servicingand resolving such Portfolios in an effort to maximize the present value of theultimate cash recoveries.

***Basis of Presentation***

The unaudited consolidatedfinancial statements of FirstCity reflect, in the opinion of management, alladjustments, consisting only of normal and recurring adjustments, necessary topresent fairly FirstCity’s consolidated financial position at June 30, 2006,its results of operations for the three and six month periods ended June 30,2006 and 2005 and cash flows for the six month periods ended June 30, 2006 and2005.  Certain disclosures have beencondensed or omitted from these financial statements. Accordingly, thesefinancial statements should be read with the consolidated financial statementsincluded in the Company’s 2005 Annual Report on Form 10-K.  Certain amounts in the consolidated financialstatements for prior years have been reclassified to conform with currentconsolidated financial statement presentation. In the first quarter of 2006, equity in earnings of investmentswas reclassified outside of revenues, which in prior periods was included withrevenues.  Also in the first quarter of2006, the Company has separately disclosed the operating, investing andfinancing portions of the cash flows attributable to its discontinuedoperations, which in prior periods were reported on a combined basis as asingle amount.  In the second quarter of2006, the Company reclassified gain on resolution of Portfolio Assets and loaninterest income as income from Portfolio Assets.  These items were reported separately in priorperiods.

***Use of Estimates***

The preparation of financial statements in conformity with U.S.generally accepted accounting principles requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent assets and liabilitiesat the date of the financial statements and the reported amounts of revenuesand expenses during the reporting period. Significant estimates include (i) theestimation of future collections on purchased Portfolio Assets used in thecalculation of income from Portfolio Assets, (ii) interest rate environments,(iii) valuation of the deferred tax asset, and (iv) prepayment speeds andcollectibility of loans held in inventory, in securitization trusts and forinvestment. Actual results could differ materially from those estimates.

***Stock-Based Compensation***

On January 1,2006, FirstCity adopted Statement of Financial Accounting Standards No. 123(revised 2004), *Share-Based Payment* (“SFAS 123(R)”),that addresses the accounting for share-based payment transactions in which anenterprise receives employee services in exchange for either equity instrumentsof the enterprise or liabilities that are based on the fair value of theenterprise’s equity instruments or that may be settled by the issuance of suchequity instruments. The statement eliminates the ability to account forshare-based compensation transactions, as the Company formerly did, using theintrinsic value method as prescribed by Accounting Principles Board, or APB,Opinion No. 25, *Accounting for Stock Issued to Employees*(“APB 25”), and generally requires that such transactions be accounted forusing a fair-value-based method and recognized as expenses in the consolidatedstatement of operations.

FirstCity adoptedSFAS 123(R) using the modified prospective method which requires theapplication of the accounting standard as of January 1, 2006. The consolidatedfinancial statements as of and for the six months ended June 30, 2006, reflectthe impact of adopting SFAS 123(R). In accordance with the modified prospectivemethod, the consolidated financial statements for prior periods have not beenrestated to reflect, and do not include, the impact of SFAS 123(R). See Note 9for further details.

6

----

** **

Table of Contents

**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS - (continued)**

 

Stock-basedcompensation expense recognized during the period is based on the value of theportion of stock-based payment awards that is ultimately expected to vest.Stock-based compensation expense recognized in the consolidated statement ofoperations during the three and six months ended June 30, 2006, includedcompensation expense for stock-based payment awards that were granted prior to,but were not yet vested, as of December 31, 2005 based on the grant date fairvalue estimated in accordance with the pro forma provisions of SFAS 148 andcompensation expense for the stock-based payment awards granted subsequent toDecember 31, 2005, based on the grant date fair value estimated in accordancewith SFAS 123(R). As stock-based compensation expense recognized in thestatement of operations for the three and six months ended June 30, 2006, isbased on awards ultimately expected to vest, it has been reduced for estimatedforfeitures. SFAS 123(R) requires forfeitures to be estimated at the time ofgrant and revised, if necessary, in subsequent periods if actual forfeituresdiffer from those estimates. In the pro forma information required under SFAS148 for the periods prior to 2006, we accounted for forfeitures as theyoccurred.

**(2)  New Accounting Pronouncements**

In July 2006, the Financial Accounting Standards Board(“FASB”) issued FASB Interpretation No. (“FIN”) 48, *Accounting for Uncertainty in Income Taxes*(“FIN No. 48”).FIN No. 48 clarifies the accounting for uncertainty in income taxes recognizedin an enterprise’s financial statements in accordance with FASB Statement ofFinancial Accounting Standards (“SFAS”) No. 109, *Accounting for Income Taxes*. FIN No. 48prescribes a recognition threshold and measurement attribute for the financialstatement recognition and measurement of a tax position taken or expected to betaken in a tax return. FIN No. 48 is effective for fiscal years beginning afterDecember 15, 2006. The Company is evaluating any future effect of thispronouncement.

In November 2005, the FASB issued FASB Staff PositionSFAS 115-1, *The Meaning of Other-Than-Temporary Impairment andIts Application to Certain Investments*(“FSP 115-1”).  FSP 115-1 addresses the determination as towhen an investment is considered impaired, whether that impairment is otherthan temporary, and the measurement of an impaired loss.  FSP 115-1 also includes accountingconsiderations subsequent to the recognition of an other-than-temporaryimpairment and requires certain disclosures about unrealized losses that havenot been recognized as other-than-temporary impairments.  The provisions of FSP 115-1 were adopted onJanuary 1, 2006, and did not have a significant impact on the Company’sconsolidated financial statements.

**(3)  Discontinued Operations**

Discontinued operations are comprised of two componentspreviously reported as the Company’s residential and commercial mortgagebanking business (“Mortgage”) and the consumer lending business (“Consumer”)conducted through the Company’s minority interest investment in Drive FinancialServices LP (“Drive”).  Losses fromdiscontinued operations are summarized as follows:
|                                        | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                             | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Mortgage                               |       | $                                               | —     |                                          | $          | (94 | ) | $ | (75 | ) | $ | (94 | ) |
| Consumer                               |       | —                                          |       | (3                                            | )          | — |   | (3 | ) |
| Net loss from  discontinued operations |       | $                                               | —     |                                          | $          | (97 | ) | $ | (75 | ) | $ | (97 | ) |

 

*Mortgage*

At June 30, 2006, the only asset remaining from discontinued mortgageoperations is an investment security resulting from the retention of a residualinterest in a securitization transaction. This security is in “run-off,” andthe Company is contractually obligated to service these assets.  The cash flows are collected over a period oftime and are valued using prepayment assumptions of 32% for fixed rate loansand 33% for variable rate loans. Overall loss rates are estimated at 14% ofcollateral.  The Company recordedprovisions of $58 and $78 in the first six months of 2006 and 2005,respectively, for losses from discontinued mortgage operations.

In April 2005, theCompany exercised an early purchase option on the 1998-1 securitization.  Loans receivable were recorded at $6.1million in accordance with EITF 02-9, *Accounting for ChangesThat Result in a Transferor Regaining Control of Financial Assets Sold. *FirstCity evaluated each loan atthe acquisition date to determine whether there was evidence of creditdeterioration since origination.  At June30, 2006, the acquired loans are included in Portfolio Assets in theconsolidated balance sheet and classified as either “loans acquired with creditdeterioration” or “loans acquired without credit deterioration.”

7

----

** **

Table of Contents

**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS - (continued)**

 

*Consumer*

There were noconsumer assets held for sale as of June 30, 2006 and December 31, 2005.  Liabilities from discontinued consumeroperations consisted of state taxes payable at June 30, 2006.

**(4)  Portfolio Assets**

Portfolio Assets are summarized as follows: 
|                                             | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                  | ** ** | **2006**          | ** ** | **2005**              | ** ** |
| Loan Portfolios                             | ** ** | ** **        | ** ** | ** **            | ** ** |
| Loans Acquired Prior to 2005                | ** ** | ** **        | ** ** | ** **            | ** ** |
| Non-performing Portfolio Assets             |       | $                 | 8,355      |                  | $          | 10,528 |   |
| Performing Portfolio Assets                 |       | 7,009             |       | 12,029                |       |
| Loans Acquired After 2004                   | ** ** | ** **        | ** ** | ** **            | ** ** |
| Loans acquired with credit deterioration    |       | 30,546            |       | 12,703                |       |
| Loans acquired with no credit deterioration |       | 3,292             |       | 3,976                 |       |
| Outstanding balance                         |       | 49,202            |       | 39,236                |       |
| Allowance for loan losses                   |       | (197              | )          | (163                  | )          |
| Carrying amount of loans, net of allowance  |       | 49,005            |       | 39,073                |       |
|                                        |       |              |       |                  |       |
| Real Estate  Portfolios                     |       | 4,958             |       | 8,018                 |       |
| Other                                       |       | 4,042             |       | 2,255                 |       |
| Portfolio  Assets, net                      |       | $                 | 58,005     |                  | $          | 49,346 |   |

 

Income from Portfolio Assets is summarized as follows:
|                                             | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                  | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Loan Portfolios                             |       |                                            |       |                                          |       |   |   |   |   |
| Loans Acquired Prior to 2005                |       |                                            |       |                                          |       |   |   |   |   |
| Non-performing Portfolio Assets             |       | $                                               | 886        |                                          | $          | 988 |   | $ | 1,852 |   | $ | 2,583 |   |
| Performing Portfolio Assets                 |       | 428                                             |       | 602                                           |       | 881 |   | 1,347 |   |
| Loans Acquired After 2004                   |       |                                            |       |                                          |       |   |   |   |   |
| Loans acquired with credit deterioration    |       | 698                                             |       | 111                                           |       | 1,009 |   | 111 |   |
| Loans acquired with no credit deterioration |       | 89                                              |       | 74                                            |       | 184 |   | 74 |   |
| Real Estate  Portfolios                     |       | 698                                             |       | 30                                            |       | 872 |   | 30 |   |
| Other                                       |       | 147                                             |       | —                                        |       | 206 |   | — |   |
| Income from  Portfolio Assets               |       | $                                               | 2,946      |                                          | $          | 1,805 |   | $ | 5,004 |   | $ | 4,145 |   |

 

Portfolio Assets are pledged to secure notes payable that arenon-recourse to FirstCity or any affiliate other than the entity that incurredthe debt.  See Note 2 to the Company’s2005 Annual Report on Form 10-K for a description of the Revolving Creditagreement between FH Partners, L.P. and Bank of Scotland, which is guaranteedby FirstCity and the primary wholly-owned subsidiaries of FirstCity.

The Company recorded a provision for loan andimpairment losses on Portfolio Assets of approximately $51 for the six monthperiod ended June 30, 2006, which is comprised of $2 impairment charge on realestate portfolios and $49 allowance for loan losses.  For the six month period ended June 30, 2005,the Company recorded an allowance for impairment on Portfolio Assets of $114,which is comprised wholly of allowance for loan losses.

8

----

** **

Table of Contents

**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS - (continued)**

The changes in the allowance for loan losses are asfollows:
|                    | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **         | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Beginning  Balance |       | $                                               | (255       | )                                             | $          | (85 | ) | $ | (163 | ) | $ | — |   |
| Provisions         |       | (34                                             | )          | (29                                           | )          | (141 | ) | (114 | ) |
| Recoveries         |       | 92                                              |       | —                                        |       | 92 |   | — |   |
| Charge Offs        |       | —                                          |       | —                                        |       | 15 |   | — |   |
| Ending Balance     |       | $                                               | (197       | )                                             | $          | (114 | ) | $ | (197 | ) | $ | (114 | ) |

 

Changes in accretable yield for loans acquired withcredit deterioration are as follows:
|                                                     | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                          | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
|  Beginning Balance                             |       | $                                               | 4,808      |                                          | $          | — |   | $ | 3,765 |   | $ | — |   |
| Additions                                           |       | 5,550                                           |       | 3,239                                         |       | 6,904 |   | 3,239 |   |
| Accretion                                           |       | (694                                            | )          | (111                                          | )          | (1,004 | ) | (111 | ) |
| Reclassification from (to) nonaccretable difference |       | —                                          |       | —                                        |       | — |   | — |   |
| Disposals                                           |       | (4                                              | )          | —                                        |       | (5 | ) | — |   |
|  Ending Balance                                |       | $                                               | 9,660      |                                          | $          | 3,128 |   | $ | 9,660 |   | $ | 3,128 |   |

 

Loans acquired during each period for which it wasprobable at acquisition that all contractually required payments would not becollected are as follows:
|                                                           | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
|  Face value at acquisition                           |       | $                                               | 32,621     |                                          | $          | 14,497 |   | $ | 43,640 |   | $ | 14,497 |   |
|  Cash flows expected to be collected at  acquisition |       | 21,109                                          |       | 13,991                                        |       | 29,964 |   | 13,991 |   |
|  Basis in acquired loans at  acquisition             |       | 15,559                                          |       | 10,751                                        |       | 23,060 |   | 10,751 |   |
|                                                           |            |                                                 |            |                                               |            |  |  |  |  |  |  |  |  |

 

**(5)  Loans Receivable from AcquisitionPartnerships Held for Investment**

Loans receivable from Acquisition Partnerships held for investmentconsist primarily of loans from certain partnerships located in Mexico and aresummarized as follows:

|               | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|---------------|------------|-------------------|------------|-----------------------|------------|
| ** **    | ** ** | **2006**          | ** ** | **2005**              | ** ** |
| Latin America |       | $                 | 21,657     |                  | $          | 16,098 |   |
| Europe        |       | 2,048             |       | 1,674                 |       |
| Domestic      |       | 2,084             |       | 1,834                 |       |
|          |       | $                 | 25,789     |                  | $          | 19,606 |   |

 

In May 2006, FirstCity andCargill acquired the outstanding loan and equity interest in certain MexicanPartnerships that were owned by other investors.  As a result, FirstCity’s loans receivableincreased by $6.2 million.

There were no provisions recorded on these loansduring the first six months of 2006 and 2005. The loans receivable from Acquisition Partnerships are secured by theassets/loans acquired by the partnerships with purchase money loans provided byaffiliates of the investors to the partnerships to purchase the asset poolsheld in those entities. These loans are evaluated for impairment by analyzingthe expected future cash flows from the underlying assets within each pool todetermine that the cash flows were sufficient to repay these notes. The Companyapplies the asset valuation methodology consistently in all venues and uses thesame proprietary asset management system to evaluate impairment on all assetpools. The results of this evaluation indicated that cash flows from the poolswill be sufficient to repay the loans and no allowances for impairment arenecessary.

9

----

** **

Table of Contents

**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS - (continued)**

 

Equity method losses which were recorded to reduce theloans and interest receivable from certain Mexican partnerships were $.9million and $.08 million during the first six months of 2006 and 2005,respectively, in compliance with EITF 98-13, *Accountingby an Equity Method Investor for Investee Losses When the Investor Has Loans toand Investments in Other Securities of the Investee*, and EITF 99-10,*Percentage Used to Determine the Amount of EquityMethod Losses.*

**(6)  Equity Investments**

The Company has investments in Acquisition Partnerships and their generalpartners and investments in servicing entities that are accounted for under theequity method.  The condensed combinedfinancial position and results of operations of the Acquisition Partnerships(excluding servicing entities), which include the domestic and foreignAcquisition Partnerships and their general partners, are summarized below:

**Condensed Combined Balance Sheets**

 

|                                                | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                     | ** ** | **2006**          | ** ** | **2005**              | ** ** |
| Assets                                         |       | $                 | 397,337    |                  | $          | 444,825 |   |
| Liabilities                                    |       | $                 | 343,807    |                  | $          | 340,881 |   |
| Net equity                                     |       | 53,530            |       | 103,944               |       |
|                                           |       | $                 | 397,337    |                  | $          | 444,825 |   |
|                                           |       |              |       |                  |       |
| Equity  investment in Acquisition Partnerships |       | $                 | 62,330     |                  | $          | 77,893 |   |
| Equity  investment in servicing entities       |       | 5,669             |       | 5,892                 |       |
|                                           |       | $                 | 67,999     |                  | $          | 83,785 |   |

 

**Condensed Combined Summary of Operations**

 

|                                                 | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                      | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Proceeds from  resolution of Portfolio Assets   |       | $                                               | 45,071     |                                          | $          | 63,048 |   | $ | 77,229 |   | $ | 108,700 |   |
| Gain on  resolution of Portfolio Assets         |       | 15,242                                          |       | 25,650                                        |       | 30,284 |   | 45,814 |   |
| Interest income  on Portfolio Assets            |       | 4,250                                           |       | 2,649                                         |       | 8,222 |   | 4,755 |   |
| Net earnings  (loss)                            |       | $                                               | (9,114     | )                                             | $          | 11,874 |   | $ | 3,707 |   | $ | 20,906 |   |
|                                            |       |                                            |       |                                          |       |   |   |   |   |
| Equity in  earnings of Acquisition Partnerships |       | $                                               | 1,128      |                                          | $          | 3,362 |   | $ | 4,819 |   | $ | 6,410 |   |
| Equity in  earnings of servicing entities       |       | 259                                             |       | 328                                           |       | 202 |   | 681 |   |
|                                            |       | $                                               | 1,387      |                                          | $          | 3,690 |   | $ | 5,021 |   | $ | 7,091 |   |

 

10

----

** **

Table of Contents

**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS - (continued)**

The assets and equity of the Acquisition Partnerships and equityinvestments in the Acquisition Partnerships are summarized by geographic regionbelow. The WAMCO Partnerships represent limited partnerships and limitedliability companies in which the Company has a common ownership withCargill.  MinnTex Investment Partners LPis considered to be a significant subsidiary of FirstCity.

|                                                 | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2006**          | ** ** | **2005**              | ** ** |
| Assets:                                         |       |              |       |                  |       |
|  Domestic:                                 |       |              |       |                  |       |
| WAMCO Partnerships                              |       | $                 | 164,843    |                  | $          | 166,213 |   |
| MinnTex Investment Partners LP                  |       | 149               |       | 307                   |       |
| Other                                           |       | 10,562            |       | 10,410                |       |
|  Latin America                             |       | 152,291           |       | 185,702               |       |
|  Europe                                    |       | 69,492            |       | 82,193                |       |
|                                            |       | $                 | 397,337    |                  | $          | 444,825 |   |
|                                            |       |              |       |                  |       |
| Equity  (deficit):                              |       |              |       |                  |       |
|  Domestic:                                 |       |              |       |                  |       |
| WAMCO Partnerships                              |       | $                 | 80,879     |                  | $          | 111,329 |   |
| MinnTex Investment Partners LP                  |       | 132               |       | 283                   |       |
| Other                                           |       | 5,603             |       | 5,485                 |       |
|  Latin America                             |       | (89,335           | )          | (79,527               | )          |
|  Europe                                    |       | 56,251            |       | 66,374                |       |
|                                            |       | $                 | 53,530     |                  | $          | 103,944 |   |
| Equity  investment in Acquisition Partnerships: |       |              |       |                  |       |
|  Domestic:                                 |       |              |       |                  |       |
| WAMCO Partnerships                              |       | $                 | 37,053     |                  | $          | 51,772 |   |
| MinnTex Investment Partners LP                  |       | 43                |       | 93                    |       |
| Other                                           |       | 2,707             |       | 2,825                 |       |
|  Latin America                             |       | 3,483             |       | 2,771                 |       |
|  Europe                                    |       | 19,044            |       | 20,432                |       |
|                                            |       | $                 | 62,330     |                  | $          | 77,893 |   |

 

11

----

** **

Table of Contents

**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS - (continued)**

 

Revenues and earnings (loss) of the Acquisition Partnerships and equityin earnings (loss) of the Acquisition Partnerships are summarized by geographicregion below.
|                                           | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenues:                                 |       |                                            |       |                                          |       |   |   |   |   |
|  Domestic:                           |       |                                            |       |                                          |       |   |   |   |   |
| WAMCO Partnerships                        |       | $                                               | 7,122      |                                          | $          | 8,066 |   | $ | 14,499 |   | $ | 17,008 |   |
| MinnTex Investment Partners LP            |       | 323                                             |       | 1,502                                         |       | 889 |   | 3,107 |   |
| Other                                     |       | 4                                               |       | 32                                            |       | 296 |   | 66 |   |
|  Latin America                       |       | 7,134                                           |       | 5,815                                         |       | 12,797 |   | 11,214 |   |
|  Europe                              |       | 5,275                                           |       | 13,020                                        |       | 11,546 |   | 19,543 |   |
| ** **                                |       | $                                               | 19,858     |                                          | $          | 28,435 |   | $ | 40,027 |   | $ | 50,938 |   |
|                                      |       |                                            |       |                                          |       |   |   |   |   |
| Net earnings  (loss):                     |       |                                            |       |                                          |       |   |   |   |   |
|  Domestic:                           |       |                                            |       |                                          |       |   |   |   |   |
| WAMCO Partnerships                        |       | $                                               | 3,282      |                                          | $          | 3,422 |   | $ | 7,305 |   | $ | 7,627 |   |
| MinnTex Investment Partners LP            |       | 287                                             |       | 1,343                                         |       | 797 |   | 2,776 |   |
| Other                                     |       | (211                                            | )          | (126                                          | )          | (144 | ) | (233 | ) |
|  Latin America                       |       | (16,246                                         | )          | 2,868                                         |       | (12,319 | ) | 2,745 |   |
|  Europe                              |       | 3,774                                           |       | 4,367                                         |       | 8,068 |   | 7,991 |   |
|                                      |       | $                                               | (9,114     | )                                             | $          | 11,874 |   | $ | 3,707 |   | $ | 20,906 |   |
| Equity in  earnings (loss) of Acquisition |       |                                            |       |                                          |       |   |   |   |   |
|  Partnerships:                       |       |                                            |       |                                          |       |   |   |   |   |
|  Domestic:                           |       |                                            |       |                                          |       |   |   |   |   |
| WAMCO Partnerships                        |       | $                                               | 1,580      |                                          | $          | 1,499 |   | $ | 3,632 |   | $ | 3,356 |   |
| MinnTex Investment Partners LP            |       | 95                                              |       | 443                                           |       | 263 |   | 916 |   |
| Other                                     |       | (90                                             | )          | (31                                           | )          | (41 | ) | (48 | ) |
|  Latin America                       |       | (1,575                                          | )          | 365                                           |       | (1,131 | ) | 191 |   |
|  Europe                              |       | 1,118                                           |       | 1,086                                         |       | 2,096 |   | 1,995 |   |
|                                      |       | $                                               | 1,128      |                                          | $          | 3,362 |   | $ | 4,819 |   | $ | 6,410 |   |

 

12

----

** **

Table of Contents

**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS - (continued)**

 

Combining statements of operations for the WAMCO Partnerships follow.WAMCO 30, WAMCO 31 and WAMCO 33 are considered to be significant subsidiariesof FirstCity.

**Three Months Ended June 30, 2006**

 
|                                                 | ** ** | **WAMCO** | ** ** | **WAMCO** | ** ** | **WAMCO** | ** ** | **Other**        | ** ** | ** **   | ** ** |
|-------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|------------------|------------|--------------|------------|
| ** **                                      | ** ** | **30**    | ** ** | **31**    | ** ** | **33**    | ** ** | **Partnerships** | ** ** | **Combined** | ** ** |
| Proceeds from  resolution of Portfolio Assets   |       | $         | 3,769      |      | $          | 4,554     |       | $                | 10,909     |         | $          | 2,048 |   | $ | 21,280 |   |
| Cost of  Portfolio Assets resolved              |       | 2,778     |       | 3,659     |       | 9,601     |       | 966              |       | 17,004       |       |
| Gain on  resolution of Portfolio Assets         |       | 991       |       | 895       |       | 1,308     |       | 1,082            |       | 4,276        |       |
| Interest income  on Portfolio Assets            |       | 189       |       | 89        |       | 383       |       | 1,999            |       | 2,660        |       |
| Other income,  net                              |       | 10        |       | 9         |       | 11        |       | 156              |       | 186          |       |
| Revenues                                        |       | 1,190     |       | 993       |       | 1,702     |       | 3,237            |       | 7,122        |       |
| Interest and  fees expense — affiliate     |       | —    |       | —    |       | —    |       | (155             | )          | (155         | )          |
| Interest and  fees expense — other         |       | (54       | )          | (207      | )          | (308      | )          | (222             | )          | (791         | )          |
| Provision for  loan and impairment losses       |       | 53        |       | (120      | )          | (4        | )          | (496             | )          | (567         | )          |
| Service fees —  affiliate                  |       | (161      | )          | (146      | )          | (358      | )          | (721             | )          | (1,386       | )          |
| General,  administrative and operating expenses |       | (173      | )          | (32       | )          | (161      | )          | (575             | )          | (941         | )          |
| Expenses                                        |       | (335      | )          | (505      | )          | (831      | )          | (2,169           | )          | (3,840       | )          |
|  Net earnings                              |       | $         | 855        |      | $          | 488       |       | $                | 871        |         | $          | 1,068 |   | $ | 3,282 |   |

 

**Three Months Ended June 30, 2005**

 
|                                                 | ** ** | **WAMCO** | ** ** | **WAMCO** | ** ** | **WAMCO** | ** ** | **Other**        | ** ** | ** **   | ** ** |
|-------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|------------------|------------|--------------|------------|
| ** **                                      | ** ** | **30**    | ** ** | **31**    | ** ** | **33**    | ** ** | **Partnerships** | ** ** | **Combined** | ** ** |
| Proceeds from  resolution of Portfolio Assets   |       | $         | 4,137      |      | $          | 5,325     |       | $                | 3,377      |         | $          | 7,863 |   | $ | 20,702 |   |
| Cost of  Portfolio Assets resolved              |       | 3,098     |       | 3,880     |       | 2,724     |       | 4,335            |       | 14,037       |       |
| Gain on  resolution of Portfolio Assets         |       | 1,039     |       | 1,445     |       | 653       |       | 3,528            |       | 6,665        |       |
| Interest income  on Portfolio Assets            |       | —    |       | 138       |       | 590       |       | 657              |       | 1,385        |       |
| Other income,  net                              |       | 3         |       | 8         |       | —    |       | 5                |       | 16           |       |
| Revenues                                        |       | 1,042     |       | 1,591     |       | 1,243     |       | 4,190            |       | 8,066        |       |
| Interest and  fees expense — affiliate     |       | —    |       | —    |       | (367      | )          | (231             | )          | (598         | )          |
| Interest and  fees expense – other         |       | (59       | )          | (309      | )          | (149      | )          | (26              | )          | (543         | )          |
| Provision for  loan and impairment losses       |       | (57       | )          | —    |       | (625      | )          | (129             | )          | (811         | )          |
| Service fees —  affiliate                  |       | (137      | )          | (157      | )          | (127      | )          | (371             | )          | (792         | )          |
| General,  administrative and operating expenses |       | (160      | )          | (101      | )          | (124      | )          | (1,515           | )          | (1,900       | )          |
| Expenses                                        |       | (413      | )          | (567      | )          | (1,392    | )          | (2,272           | )          | (4,644       | )          |
|  Net earnings (loss)                       |       | $         | 629        |      | $          | 1,024     |       | $                | (149       | )            | $          | 1,918 |   | $ | 3,422 |   |

 

13

----

** **

Table of Contents

**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS - (continued)**

 

**Six Months Ended June 30, 2006**

 
|                                                 | ** ** | **WAMCO** | ** ** | **WAMCO** | ** ** | **WAMCO** | ** ** | **Other**        | ** ** | ** **   | ** ** |
|-------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|------------------|------------|--------------|------------|
| ** **                                      | ** ** | **30**    | ** ** | **31**    | ** ** | **33**    | ** ** | **Partnerships** | ** ** | **Combined** | ** ** |
| Proceeds from  resolution of Portfolio Assets   |       | $         | 4,597      |      | $          | 5,103     |       | $                | 12,853     |         | $          | 9,144 |   | $ | 31,697 |   |
| Cost of  Portfolio Assets resolved              |       | 3,367     |       | 4,071     |       | 11,076    |       | 5,153            |       | 23,667       |       |
| Gain on  resolution of Portfolio Assets         |       | 1,230     |       | 1,032     |       | 1,777     |       | 3,991            |       | 8,030        |       |
| Interest income  on Portfolio Assets            |       | 189       |       | 198       |       | 824       |       | 3,979            |       | 5,190        |       |
| Other income,  net                              |       | 15        |       | 12        |       | 11        |       | 1,241            |       | 1,279        |       |
| Revenues                                        |       | 1,434     |       | 1,242     |       | 2,612     |       | 9,211            |       | 14,499       |       |
| Interest and  fees expense — affiliate     |       | —    |       | —    |       | —    |       | (325             | )          | (325         | )          |
| Interest and  fees expense — other         |       | (54       | )          | (424      | )          | (624      | )          | (222             | )          | (1,324       | )          |
| Provision for  loan and impairment losses       |       | (67       | )          | (120      | )          | (186      | )          | (857             | )          | (1,230       | )          |
| Service fees —  affiliate                  |       | (198      | )          | (190      | )          | (443      | )          | (1,346           | )          | (2,177       | )          |
| General,  administrative and operating expenses |       | (208      | )          | (66       | )          | (297      | )          | (1,567           | )          | (2,138       | )          |
| Expenses                                        |       | (527      | )          | (800      | )          | (1,550    | )          | (4,317           | )          | (7,194       | )          |
|  Net earnings                              |       | $         | 907        |      | $          | 442       |       | $                | 1,062      |         | $          | 4,894 |   | $ | 7,305 |   |

 

**Six Months Ended June 30, 2005**

 
|                                                 | ** ** | **WAMCO** | ** ** | **WAMCO** | ** ** | **WAMCO** | ** ** | **Other**        | ** ** | ** **   | ** ** |
|-------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|------------------|------------|--------------|------------|
| ** **                                      | ** ** | **30**    | ** ** | **31**    | ** ** | **33**    | ** ** | **Partnerships** | ** ** | **Combined** | ** ** |
| Proceeds from  resolution of Portfolio Assets   |       | $         | 5,143      |      | $          | 10,915    |       | $                | 10,427     |         | $          | 16,747 |   | $ | 43,232 |   |
| Cost of Portfolio  Assets resolved              |       | 3,843     |       | 8,672     |       | 8,010     |       | 8,350            |       | 28,875       |       |
| Gain on  resolution of Portfolio Assets         |       | 1,300     |       | 2,243     |       | 2,417     |       | 8,397            |       | 14,357       |       |
| Interest income  on Portfolio Assets            |       | —    |       | 401       |       | 1,038     |       | 1,162            |       | 2,601        |       |
| Other income,  net                              |       | 5         |       | 14        |       | —    |       | 31               |       | 50           |       |
| Revenues                                        |       | 1,305     |       | 2,658     |       | 3,455     |       | 9,590            |       | 17,008       |       |
| Interest and  fees expense – affiliates    |       | —    |       | —    |       | (893      | )          | (427             | )          | (1,320       | )          |
| Interest and  fees expense – other         |       | (151      | )          | (630      | )          | (149      | )          | (71              | )          | (1,001       | )          |
| Provision for  loan losses                      |       | (57       | )          | —    |       | (675      | )          | (171             | )          | (903         | )          |
| Service fees –  affiliate                  |       | (183      | )          | (359      | )          | (377      | )          | (880             | )          | (1,799       | )          |
| General,  administrative and operating expenses |       | (245      | )          | (192      | )          | (243      | )          | (3,678           | )          | (4,358       | )          |
| Expenses                                        |       | (636      | )          | (1,181    | )          | (2,337    | )          | (5,227           | )          | (9,381       | )          |
|  Net earnings                              |       | $         | 669        |      | $          | 1,477     |       | $                | 1,118      |         | $          | 4,363 |   | $ | 7,627 |   |

 

Statements of operations for MinnTex Investment Partners LP for the threeand six month periods ended June 30, 2006 and 2005 follow:
|                                                 | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                      | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| Proceeds from  resolution of Portfolio Assets   |       | $                                | 325        |                           | $          | 1,525 |   | $ | 898 |   | $ | 3,164 |   |
| Cost of Portfolio  Assets resolved              |       | 3                                |       | 26                             |       | 12 |   | 62 |   |
| Gain on resolution of  Portfolio Assets         |       | 322                              |       | 1,499                          |       | 886 |   | 3,102 |   |
| Other income                                    |       | 1                                |       | 3                              |       | 3 |   | 5 |   |
| Revenues                                        |       | 323                              |       | 1,502                          |       | 889 |   | 3,107 |   |
| Service fees —  affiliate                  |       | (32                              | )          | (152                           | )          | (81 | ) | (316 | ) |
| General, administrative  and operating expenses |       | (4                               | )          | (7                             | )          | (11 | ) | (15 | ) |
| Expenses                                        |       | (36                              | )          | (159                           | )          | (92 | ) | (331 | ) |
|  Net earnings                              |       | $                                | 287        |                           | $          | 1,343 |   | $ | 797 |   | $ | 2,776 |   |

 

FirstCity holds variable interests in certainAcquisition Partnerships, which would be characterized as variable interestentities (“VIE”), as defined in FIN 46R, *Consolidation of VariableInterest Entities* (“FIN 46R”). However, FirstCity is not deemed tobe the

14

----

** **

Table of Contents

**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS - (continued)**

primary beneficiary of any of these entities based onthe criteria set forth in FIN 46R. At June 30, 2006, FirstCity’s maximum exposureto loss as a result of its involvement with the VIEs is $28 million.

At June 30, 2006, the Company had $16.4 million inEuro-denominated debt for the purpose of hedging a portion of the net equityinvestments in Europe. In general, the type of risk hedged relates to theforeign currency exposure of net investments in Europe caused by movements inEuro exchange rates. The Company designated the hedging relationship such thatchanges in the net investments being hedged are expected to be offset by correspondingchanges in the values of the Euro-denominated debt. Effectiveness of thehedging relationship is measured and designated at the beginning of each monthby comparing the outstanding balance of the Euro-denominated debt to thecarrying value of the designated net equity investments. The net foreigncurrency translation gain (loss) included in accumulated other comprehensiveincome relating to the Euro-denominated debt was ($1.5) million for the sixmonths ended June 30, 2006 and $.8 million for the same period in 2005.

**(7)  Segment Reporting**

The Company is engaged in one reportable segment - Portfolio Assetacquisition and resolution.  ThePortfolio Asset acquisition and resolution business involves acquiringPortfolio Assets at a discount to face value and servicing and resolving suchPortfolios in an effort to maximize the present value of the ultimate cashrecoveries.  The following is a summaryof results of operations for the Portfolio Asset acquisition and resolutionsegment and reconciliation to earnings from continuing operations for the threeand six months ended June 30, 2006 and 2005.
|                                                                                          | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                               | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Portfolio  Asset Acquisition and Resolution:**                                         |       |                                            |       |                                          |       |   |   |   |   |
|  Revenues:                                                                          |       |                                            |       |                                          |       |   |   |   |   |
| Servicing fees                                                                           |       | $                                               | 2,856      |                                          | $          | 2,909 |   | $ | 5,503 |   | $ | 6,081 |   |
| Income from Portfolio Assets                                                             |       | 2,946                                           |       | 1,805                                         |       | 5,004 |   | 4,145 |   |
| Interest income from affiliates                                                          |       | 465                                             |       | 449                                           |       | 895 |   | 873 |   |
| Other                                                                                    |       | 448                                             |       | 306                                           |       | 859 |   | 577 |   |
| Total                                                                                    |       | 6,715                                           |       | 5,469                                         |       | 12,261 |   | 11,676 |   |
|  Expenses:                                                                          |       |                                            |       |                                          |       |   |   |   |   |
| Interest and fees on notes payable                                                       |       | 1,948                                           |       | 848                                           |       | 3,656 |   | 1,728 |   |
| Salaries and benefits                                                                    |       | 2,504                                           |       | 2,918                                         |       | 5,437 |   | 6,187 |   |
| Provision (recovery) for loan and impairment losses                                      |       | (58                                             | )          | 29                                            |       | 51 |   | 114 |   |
| Occupancy, data processing, communication and other                                      |       | 1,195                                           |       | 1,151                                         |       | 2,192 |   | 2,299 |   |
| Minority interest                                                                        |       | (73                                             | )          | 42                                            |       | (62 | ) | 39 |   |
| Total                                                                                    |       | 5,516                                           |       | 4,988                                         |       | 11,274 |   | 10,367 |   |
|  Equity in earnings of investments                                                  |       | 1,387                                           |       | 3,690                                         |       | 5,021 |   | 7,091 |   |
|  Operating contribution before direct taxes                                         |       | $                                               | 2,586      |                                          | $          | 4,171 |   | $ | 6,008 |   | $ | 8,400 |   |
|  Operating contribution, net of direct taxes                                        |       | $                                               | 2,549      |                                          | $          | 4,128 |   | $ | 5,877 |   | $ | 8,243 |   |
|                                                                                     |       |                                            |       |                                          |       |   |   |   |   |
| **Corporate  Overhead:**                                                                 |       |                                            |       |                                          |       |   |   |   |   |
|  Salaries and benefits, occupancy,  professional and other income and expenses, net |       | 1,286                                           |       | 1,308                                         |       | 2,517 |   | 2,874 |   |
|  Earnings from continuing operations                                                |       | $                                               | 1,263      |                                          | $          | 2,820 |   | $ | 3,360 |   | $ | 5,369 |   |

 

15

----

** **

Table of Contents

**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS - (continued)**

 

Revenues and equity in earnings of investments from thePortfolio Asset acquisition and resolution segment are attributable to domesticand foreign operations as follows:
|               | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **    | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Domestic      |       | $                                               | 6,037      |                                          | $          | 4,764 |   | $ | 11,391 |   | $ | 10,726 |   |
| Latin America |       | 488                                             |       | 2,973                                         |       | 3,141 |   | 5,370 |   |
| Europe        |       | 1,577                                           |       | 1,422                                         |       | 2,750 |   | 2,671 |   |
| Total         |       | $                                               | 8,102      |                                          | $          | 9,159 |   | $ | 17,282 |   | $ | 18,767 |   |

 

Totalassets for the Portfolio Asset acquisition and resolution segment and areconciliation to total assets are as follows:
|                                               | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                    | ** ** | **2006**          | ** ** | **2005**              | ** ** |
| ** **                                    | ** ** | ** **        | ** ** | ** **            | ** ** |
| Cash                                          |       | $                 | 10,312     |                  | $          | 12,901 |   |
| Portfolio  acquisition and resolution assets: |       |              |       |                  |       |
|  Domestic                                |       | 99,951            |       | 105,938               |       |
|  Latin America                           |       | 25,588            |       | 19,764                |       |
|  Europe                                  |       | 26,684            |       | 27,699                |       |
| Deferred tax  asset, net                      |       | 20,101            |       | 20,101                |       |
| Other  non-earning assets, net                |       | 7,875             |       | 8,309                 |       |
| Discontinued  mortgage assets                 |       | 100               |       | 157                   |       |
| Total assets                                  |       | $                 | 190,611    |                  | $          | 194,869 |   |

 

**(8)  Earnings per Common Share**

Basic net earnings per common share calculations arebased upon the weighted average number of common shares outstanding.Potentially dilutive common share equivalents include warrants and employeestock options in the diluted earnings per common share calculations.  Basic and diluted earnings from continuingoperations per share were determined as follows:
|                                                                                   | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                        | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Earnings from  continuing operations                                              |       | $                                               | 1,263      |                                          | $          | 2,820 |   | $ | 3,360 |   | $ | 5,369 |   |
|                                                                              |       |                                            |       |                                          |       |   |   |   |   |
| Weighted average  outstanding shares of common stock                              |       | 11,308                                          |       | 11,274                                        |       | 11,308 |   | 11,268 |   |
| Dilutive effect  of:                                                              |       |                                            |       |                                          |       |   |   |   |   |
| Warrants                                                                          |       | 340                                             |       | 346                                           |       | 340 |   | 344 |   |
| Employee stock options                                                            |       | 311                                             |       | 405                                           |       | 310 |   | 404 |   |
| Weighted average  outstanding shares of common stock and common stock equivalents |       | 11,959                                          |       | 12,025                                        |       | 11,958 |   | 12,016 |   |
| Earnings from  continuing operations per share:                                   |       |                                            |       |                                          |       |   |   |   |   |
| Basic                                                                             |       | $                                               | 0.11       |                                          | $          | 0.25 |   | $ | 0.30 |   | $ | 0.48 |   |
| Diluted                                                                           |       | $                                               | 0.11       |                                          | $          | 0.24 |   | $ | 0.28 |   | $ | 0.45 |   |

 

**(9)  Stock-Based Compensation**

The Company has a stock option and award plan for thebenefit of key individuals, including its directors, officers and keyemployees. The plan is administered by a committee of the Board of Directorsand provides for the grant of up to a total of 300,000 shares (net of sharescancelled and forfeited) of Common Stock. The Company previously had a 1995 Stock Option and Award Plan, and a1996 Stock Option and Award Plan, which provided for a grant of up to 700,000shares.  Both plans expired in 2005pursuant to

16

----

** **

Table of Contents

**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS - (continued)**

 

their terms, with existing options remaining inaccordance with the terms of each grant. Stock option awards are granted with an exercise price equal to themarket price of FirstCity’s shares at the date of grant; those stock optionawards generally vest 25% each year from the date of grant and have 10-yearcontractual terms.  Certain stock optionsissued to non-employee directors in 2004 and 2005 were exercisable immediately.

FirstCity adopted SFAS 123(R) using the modifiedprospective transition method beginning January 1, 2006. Accordingly, duringthe three and six month periods ended June 30, 2006, the Company recordedstock-based compensation expense for awards granted prior to, but not yetvested, as of January 1, 2006, as if the fair value method required for proforma disclosure under SFAS 123 were in effect for expense recognitionpurposes, adjusted for estimated forfeitures. For these awards, we recognizedcompensation expense using the straight-line amortization method. Forstock-based awards granted after January 1, 2006, the Company will recognizecompensation expense based on the estimated grant date fair value method usingthe Black-Scholes valuation model. For these awards, FirstCity will recognizecompensation expense using a straight-line amortization method. As SFAS 123(R)requires that stock-based compensation expense be based on awards that areultimately expected to vest, stock-based compensation for the three and sixmonth periods ended June 30, 2006 has been reduced for estimated forfeitures.When estimating forfeitures, FirstCity considers voluntary terminationbehaviors as well as trends of actual option forfeitures. The impact on theresults of operations of recording stock-based compensation for the three andsix month periods ended June 30, 2006 and 2005 was as follows:
|                                                   | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                        | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Amount of  compensation cost recognized in income |       | $                                               | 101        |                                          | $          | — |   | $ | 246 |   | $ | — |   |
| Tax benefit  recognized in income                 |       | $                                               | —     |                                          | $          | — |   | $ | — |   | $ | — |   |
| Amount capitalized as part  of an asset           |       | $                                               | —     |                                          | $          | — |   | $ | — |   | $ | — |   |

 

SFAS 123(R) requires cash flows resulting from excesstax benefits to be classified as a part of cash flows from financingactivities. Excess tax benefits are realized tax benefits from tax deductionsfor exercised options in excess of the deferred tax asset attributable to stockcompensation costs for such options. As a result of substantial net operatingloss carryforwards, the Company currently does not record deferred tax assetsattributable to stock compensation costs nor does it utilize tax deductions forexercised options. Cash received from options exercised during the six monthperiods ended June 30, 2006 and 2005 was $5 and $118, respectively.

The fair value of stock options granted was estimatedon the date of grant using the Black-Scholes option pricing model. Expectedvolatilities are based on historical volatility of the Company’s stock. TheCompany estimated the expected term of unvested options by taking the averageof the vesting term remaining and the contractual term of the option, asillustrated in the Securities and Exchange Commission’s Staff AccountingBulletin No. 107.  The expected liferepresents the period of time that options granted are expected to beoutstanding. The risk-free rate is based on the U.S. Treasury rate with amaturity date corresponding to the options’ expected life.  There were no options granted during the sixmonth periods ended June 30, 2006 and 2005.

A summary of stock option activity as of June 30, 2006and changes during the period then ended is presented below:

17

----

** **

Table of Contents

**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS - (continued)**

 

|                                 | ** ** | ** ** | ** ** | ** **   | ** ** | **Weighted**    | ** ** | ** **    | ** ** |
|---------------------------------|------------|------------|------------|--------------|------------|-----------------|------------|---------------|------------|
| ** **                      | ** ** | ** ** | ** ** | ** **   | ** ** | **Average**     | ** ** | ** **    | ** ** |
| ** **                      | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Remaining**   | ** ** | ** **    | ** ** |
| ** **                      | ** ** | ** ** | ** ** | **Average**  | ** ** | **Contractual** | ** ** | **Aggregate** | ** ** |
| ** **                      | ** ** | ** ** | ** ** | **Exercise** | ** ** | **Term**        | ** ** | **Intrinsic** | ** ** |
| ** **                      | ** ** | **Shares** | ** ** | **Price**    | ** ** | **(Years)**     | ** ** | **Value**     | ** ** |
| Outstanding at January  1, 2006 |       | 755,850    |       | $            | 7.02       |            |       |          |       |   |
| Granted                         |       | —     |       | —       |       |            |       |          |       |
| Exercised                       |       | (2,250     | )          | 2.47         |       |            |       |          |       |
| Expired                         |       | —     |       | —       |       |            |       |          |       |
| Forfeited                       |       | (2,000     | )          | 27.25        |       |            |       |          |       |
| Outstanding at June  30, 2006   |       | 751,600    |       | $            | 6.98       |            | 6.37       |          | $          | 3,533 |   |
| Exercisable at June 30,  2006   |       | 553,575    |       | $            | 6.19       |            | 5.60       |          | $          | 3,165 |   |

 

The total intrinsic value of stock options exercisedduring the three and six month periods ended June 30, 2006 were $20 and $20,respectively.  The total intrinsic valueof stock options exercised during the three and six month periods ended June30, 2005 were $271 and $293, respectively. As of June 30, 2006, there was approximately $1.2 million of totalunrecognized compensation cost related to unvested share-based compensationarrangements granted under the stock option plans.  That cost is expected to be recognized over aweighted average period of 2.6 years.

A summary of the status and changes of FirstCity’snonvested shares as of June 30, 2006, and changes during the six months endedJune 30, 2006 is presented below:

|                               | ** ** | ** ** | ** ** | **Weighted-**       | ** ** |
|-------------------------------|------------|------------|------------|---------------------|------------|
| ** **                    | ** ** | ** ** | ** ** | **Average**         | ** ** |
| ** **                    | ** ** | ** ** | ** ** | **Grant-Date**      | ** ** |
| ** **                    | ** ** | **Shares** | ** ** | **Fair Value** | ** ** |
| Nonvested at  January 1, 2006 |       | 253,525    |       | $                   | 6.58       |   |
| Granted                       |       | —     |       | —              |       |
| Vested                        |       | (55,500    | )          | $                   | 5.19       |   |
| Forfeited                     |       | —     |       | —              |       |
| Nonvested at June 30,  2006   |       | 198,025    |       | $                   | 6.97       |   |

 

Prior to the adoption of SFAS No. 123(R), FirstCityprovided the disclosures required under SFAS No. 123, as amended by SFAS No.148, *Accounting for Stock-Based Compensation —Transition and Disclosures*. Employee stock-based compensationexpense recognized under SFAS 123(R) was not reflected in the results ofoperations for the three and six month periods ended June 30, 2005 for employeestock option awards, as all options were granted with an exercise price equalto the market value of the underlying common stock on the date of grant.Forfeitures of awards were recognized as they occurred. Previously reportedamounts have not been restated.

18

----

** **

Table of Contents

**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS - (continued)**

 

The pro forma information for the three and six monthperiods ended June 30, 2005 was as follows:

|                                                                                                                                             | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                                                                                  | ** ** | **2005**                                        | ** ** | **2005**                                      | ** ** |
| Net earnings to  common stockholders, as reported                                                                                           |       | $                                               | 2,723      |                                          | $          | 5,272 |   |
| Less: Total stock-based employee compensation  expense determined under fair value based method for all awards, net of  related tax effects |       | (76                                             | )          | (150                                          | )          |
| Pro forma net  earnings to common stockholders                                                                                              |       | $                                               | 2,647      |                                          | $          | 5,122 |   |
| Net earnings per  common share:                                                                                                             |       |                                            |       |                                          |       |
| Basic — as reported                                                                                                                    |       | $                                               | 0.24       |                                          | $          | 0.47 |   |
| Basic — pro  forma                                                                                                                     |       | $                                               | 0.23       |                                          | $          | 0.45 |   |
| Diluted — as  reported                                                                                                                 |       | $                                               | 0.23       |                                          | $          | 0.44 |   |
| Diluted — pro forma                                                                                                                    |       | $                                               | 0.22       |                                          | $          | 0.43 |   |

 

**(10)  Income Taxes**

Federal income taxes are provided at a 35% rate. The Company hassubstantial net operating loss carryforwards for federal income tax purposes (“NOLs”),which can be used to offset the tax liability associated with the Company’spre-tax earnings until the earlier of the expiration or utilization of suchNOLs. The Company accounts for the benefit of the NOLs by recording the benefitas an asset and then establishing a valuation allowance to value the netdeferred tax asset at a level, which more likely than not, will be realized.Realization is determined based on management’s expectation of generatingsufficient taxable income in a look forward period over the next four years.The ultimate realization of the resulting net deferred tax asset is dependentupon generating sufficient taxable income from its continuing operations priorto expiration of the NOLs. Although realization is not assured, managementbelieves it is more likely than not that all of the recorded deferred taxasset, net of the allowance, will be realized. The amount of the deferred taxasset considered realizable, however, could be adjusted in the future ifestimates of future taxable income during the carryforward period change. Theability of the Company to realize the deferred tax asset is periodicallyreviewed and the valuation allowance is adjusted accordingly.

**(11)  Commitments and Contingencies**

Periodically, FirstCity, its subsidiaries, itsaffiliates and the Acquisition Partnerships are parties to or otherwiseinvolved in legal proceedings arising in the normal course of business. FirstCitydoes not believe that there is any proceeding threatened or pending against it,its subsidiaries, its affiliates or the Acquisition Partnerships which, ifdetermined adversely, would have a material adverse effect on the consolidatedfinancial position, results of operations or liquidity of FirstCity, itssubsidiaries, its affiliates or the Acquisition Partnerships.

In August 2000, FirstCity Consumer Lending Corporation(“Consumer Corp.”) and FirstCity Funding LP (“Funding LP”) contributed all ofthe assets utilized in the operations of the automobile finance operation toDrive Financial Services LP (“Drive”) pursuant to the terms of a Contribution and Assumption Agreement by andbetween Consumer Corp. and Drive, and a Contribution and Assumption Agreementby and between Funding LP and Drive (collectively, the “Contribution Agreements”).Drive assumed substantially all of the liabilities of the automobile financeoperation as set forth in the Contribution Agreements.  In addition, pursuant to the terms of aSecurities Purchase Agreement dated as of August 18, 2000 (the “2000 SecuritiesPurchase Agreement”), by and among FirstCity, Consumer Corp., Funding LP, andFirstCity Funding GP Corp. (“Funding GP”), IFA Drive GP Holdings LLC (“IFA-GP”)and IFA Drive LP Holdings LLC (“IFA-LP”); FirstCity, Consumer Corp., Funding LPand Funding GP made various warranties concerning (i) their respectiveorganizations, (ii) the automobile finance operation conducted by ConsumerCorp. and Funding LP, and (iii) the assets transferred by Consumer Corp. andFunding LP to Drive. The Company, Consumer Corp., Funding LP and Funding GPalso agreed to indemnify BoS (USA), IFA-GP and IFA-LP from damages resultingfrom a breach of any representation or warranty contained in the 2000 SecuritiesPurchase Agreement or otherwise made by the Company, Consumer Corp. or FundingLP in connection with the transaction. All indemnity obligations under the 2000Securities Purchase Agreement terminated after thirty (30) months, with theexception of tax-related representations and warranties which survive for aperiod of seven (7) years from August 25, 2000 (the “2000 Closing Date”).Neither the Company, Consumer Corp., Funding LP, or Funding GP is required tomake any payments as a result of the indemnity provided under the 2000Securities Purchase Agreement until the aggregate amount payable exceeds $.25million, and then only for the amount in excess of $.25 million in theaggregate; however certain representations and warranties are not subject tothis $.25 million threshold.  Managementof the Company believes that FirstCity will not have to pay any amounts relatedto these agreements.

19

----

** **

Table of Contents

**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS - (continued)**

 

On September 21, 2004, FirstCity, Consumer Corp.,Funding LP and Funding GP entered into a Securities Purchase Agreement (the “2004Securities Purchase Agreement”) to sell a 31% beneficial ownership interest inDrive and its general partner, Drive GP LLC, to IFA GP, IFA LP and DriveManagement LP (“MG-LP”). In the 2004Securities Purchase Agreement, FirstCity, Consumer Corp., Funding LP andFunding GP made various representations and warranties concerning (i) theirrespective organizations, (ii) their power and authority to enter into the 2004Securities Purchase Agreement and the transactions contemplated therein, (iii)the ownership of the limited partnership interests in Drive by Funding LP, (iv)the ownership of membership interests in Drive-GP by Consumer Corp., and (iv)the capital structure of Funding LP. FirstCity, Consumer Corp., Funding LP andFunding GP also agreed to indemnify BoS (USA), IFA-GP, IFA-LP and MG-LP from damagesresulting from a breach of any representation or warranty contained in the 2004Securities Purchase Agreement or otherwise made by FirstCity, Consumer Corp. orFunding LP in connection with the transaction. The indemnity obligations underthe 2004 Securities Purchase Agreement survive for a maximum period of five (5)years from November 1, 2004. Neither FirstCity, Consumer Corp., Funding LP, orFunding GP is required to make any payments as a result of the indemnityprovided under the 2004 Securities Purchase Agreement until the aggregateamount payable exceeds $.25 million, and then only for the amount in excess of$.25 million in the aggregate; however, certain representations and warrantiesare not subject to this $.25 million threshold. Management of theCompany believes that FirstCity will not have to pay any amounts relating tothese representations and warranties.

FirstCity has minority interests in variouslimited-life partnerships with a carrying value of $1.0 million at June 30,2006. The estimated amount that would be paid to the minority interest holderif the instruments were to be settled at June 30, 2006 is $1.6 million.

Financial Security Assurance Inc. (“FSA”), in itscapacity as certificate insurer under the Pooling and Servicing Agreement (the “Poolingand Servicing Agreement”), relating to the FirstCity Capital Home Equity LoanTrust 1998-2 (the “Trust”), dated as of November 1, 1998 by and among FCCapital Corp., in its capacities as seller and master servicer, and The Bank ofNew York, in its capacity as trustee (the “Trustee”), made demand on FC CapitalCorp. to repurchase certain loans that were subject to repurchase due to fraudof third parties in connection with the origination of the loans. FC CapitalCorp. agreed to provide a letter of credit in the amount of the repurchaseprice for the loans in lieu of being required to purchase the loans from theTrust.  FirstCity has obtained anddelivered to FSA, for the benefit of FC Capital Corp., an irrevocable letter ofcredit in the amount of $510,000 from the Bank of Scotland.  Pursuant to the agreement with FSA, FCCapital Corp. will have the option to purchase the loans for $510,000 prior toa call under the letter of credit.

The Company has unsecured notes payable to Terry R.DeWitt, G. Stephen Fillip and James C. Holmes, each of whom were Senior VicePresidents of FirstCity, in connection with the acquisition of the minorityinterest in FirstCity Holdings. The notes are to be periodically redeemed bythe Company for an aggregate amount of up to $3.2 million out of certain cashcollections from servicing income from Portfolios in Mexico. FirstCity valuedthe loans at the inception date using an imputed interest rate based on theCompany’s cost of funds. At June 30, 2006, these notes had an imputed balanceof $.5 million and mature in December 2011.

**(12)  Subsequent Events**

Subsequent to thequarter ended June 30, 2006, FirstCity completed a total restructure of itsinvestments in Mexico in a transaction which aligns FirstCity with AmericanInternational Group, Inc. (“AIG”). The restructure is detailed as follows:

During the periodfrom December 1998 to March 2005, FirstCity affiliates, Cargill FinancialServices International, Inc. (“CFSI”) and certain other investors acquired,indirectly through U.S. and Mexican acquisition entities (the “AcquisitionEntities”), twelve non-performing loan portfolios from financial institutionsin Mexico. The aggregate investment interest of FirstCity in the twelveportfolios was 11% as of the end of the first quarter of 2006.

During the secondquarter of 2006, FirstCity affiliates and CFSI acquired the debt and equityinterests of the other investors in the Acquisition Entities.  Following these acquisitions, the FirstCityaffiliates had, indirectly through the Acquisition Entities, an aggregateinvestment in the portfolios of 20%.  TheFirstCity affiliates that were investors and lenders in the AcquisitionEntities transferred such ownership interests and loans to Strategic MexicanInvestment Partners, L.P. (“SMIP”), an entity in which FirstCity owns a 95.75%interest.

On August 8, 2006,SMIP and AIG Global Investment Group, the asset management arm of AIG, onbehalf of various affiliates (collectively the “AIG entities”) invested in anewly established Delaware limited liability company (the “Investor LLC”), forthe

20

----

** **

Table of Contents

**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS - (continued)**

 

purpose of acquiring theMexican portfolios by purchasing the interests of Cargill and SMIP in the U.S.acquisition entities, owners of the Mexican Acquisition Entities owning theMexican portfolios.

The AIG entitiesacquired 85% and SMIP acquired 15% of the membership interests in the InvestorLLC.  SMIP’s membership interest is heldin two parts, a 9% interest which is equivalent in standing to membershipinterests held by the AIG entities.  Theremaining 6% membership interest is subordinate to all other interests until adesignated internal rate of return is achieved.

An affiliate ofFirstCity entered into a servicing agreement with the Mexican acquisitionentities to service the Mexican portfolios.

21

----

** **

Table of Contents

**Item 2. Management’sDiscussion and Analysis of Financial Condition and Results of Operations.**

**Overview**

FirstCityis a financial services company engaged in the acquisition and resolution ofportfolios of assets or single assets (collectively referred to as “PortfolioAssets”). The Portfolio Asset acquisition and resolution business involvesacquiring Portfolio Assets at a discount to face value and servicing andresolving such portfolios in an effort to maximize the present value of theultimate cash recoveries.

During the second quarterof 2006, the Company recorded earnings to common stockholders on a dilutedbasis of $1.3 million or $.11 per common share. The operating contribution fromthe Portfolio Asset acquisition and resolution segment was $2.5 millioncompared with $4.1 million for the same period in 2005. The Company was able toinvest $18.9 million in portfolio acquisitions during the quarter. Portfolioacquisition and resolution assets, comprised of equity investments, inventory,loans receivable, and interest receivable, decreased by $13.5 million in thesecond quarter of 2006 primarily due to the distribution of $18.6 million fromequity investments in Acquisition Partnerships as a result of refinancing twoportfolios and distributing the excess funds to the owners. The Company usedthe distribution from the refinancing to pay down corporate debt.

Management remainspositive on the outlook of the Company. FirstCity is currently evaluating 35different transactions representing over $4 billion in face value of assets.

TheCompany’s financial results are affected by many factors including levels ofand fluctuations in interest rates, fluctuations in the underlying values ofreal estate and other assets, the timing of and ability to liquidate assets,and the availability and prices for loans and assets acquired in all of theCompany’s businesses. The Company’s business and results of operations are alsoaffected by the availability of financing with terms acceptable to the Companyand the Company’s access to capital markets, including the securitizationmarkets.

Asa result of the significant period to period fluctuations in the revenues andearnings and losses of the Company’s Portfolio Asset acquisition and resolutionbusiness, period to period comparisons of the Company’s results of continuingoperations may not be meaningful.

Componentsof the results for the three and six month periods ended June 30, 2006 and2005, respectively, are detailed below (dollars in thousands except per sharedata):

 

|                                             | ** ** | **Three Months Ended**                         | ** ** | **Six Months Ended**                           | ** ** |
|---------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                  | ** ** | **June 30,**                                        | ** ** | **June 30,**                                        | ** ** |
| ** **                                  | ** ** | **    2006    ** | ** ** | **    2005    ** | ** ** | **    2006    ** | ** ** | **    2005    ** | ** ** |
| Portfolio Asset  Acquisition and Resolution |       | $                                                        | 2,549      |                                                     | $          | 4,128 |   | $ | 5,877 |   | $ | 8,243 |   |
| Corporate overhead                          |       | (1,286                                                   | )          | (1,308                                                   | )          | (2,517 | ) | (2,874 | ) |
| Earnings from  continuing operations        |       | 1,263                                                    |       | 2,820                                                    |       | 3,360 |   | 5,369 |   |
| Loss from  discontinued operations          |       | —                                                   |       | (97                                                      | )          | (75 | ) | (97 | ) |
| Net earnings to  common stockholders        |       | $                                                        | 1,263      |                                                     | $          | 2,723 |   | $ | 3,285 |   | $ | 5,272 |   |
| Diluted earnings per  common share          |       | $                                                        | 0.11       |                                                     | $          | 0.23 |   | $ | 0.27 |   | $ | 0.44 |   |

22

----

** **

Table of Contents

**Results of Operations**

Thefollowing discussion and analysis is based on the segment reporting informationpresented in note 7 of the Consolidated Financial Statements of the Company andshould be read in conjunction with the Consolidated Financial Statements(including the Notes thereto) included elsewhere in this Quarterly Report on Form 10-Q.

***Second Quarter 2006 Compared to Second Quarter 2005***

TheCompany reported net earnings of $1.3 million in the second quarter of 2006compared to $2.7 million in the second quarter of 2005. On a per share basis,diluted net earnings to common stockholders were $.11 in the second quarter of2006 compared to $.23 in the second quarter of 2005.

*Portfolio Asset Acquisitionand Resolution*

The operatingcontribution from the Portfolio Asset acquisition and resolution segment was $2.5million in the second quarter of 2006 compared to $4.1 million in the secondquarter of 2005. FirstCity invested $18.9 million in Portfolio acquisitionsduring the second quarter of 2006, of which $3.3 million and $15.6 million wereacquired through Acquisitions Partnerships and wholly-owned Portfolios,respectively, compared to $16.1 million in the second quarter of 2005, all ofwhich were acquired through wholly-owned Portfolios in the U.S. During thesecond quarter of 2006, $3 million and $.3 million were acquired throughAcquisition Partnerships in the U.S. and Europe; respectively. The quarter-endinvestment in Portfolio Assets increased to $58 million at June 30, 2006, from$43.9 million at June 30, 2005, as a result of acquisitions of approximately$36.2 million since the second quarter of 2005. In addition to the portfolioacquisitions during the second quarter of 2006, FirstCity invested $6.9 millionand $.20 million in Latin American and European partnerships, respectively.

*Servicing fee revenues.*Servicing fee revenues remained flat at $2.9 million in the secondquarter of 2006 compared to $2.9 million in the second quarter of 2005.

*Income from Portfolio Assets*. Income from Portfolio Assets increased to $2.9 million in the secondquarter of 2006 from $1.8 million in the second quarter of 2005 primarily dueto increased purchases of portfolio assets and an increase in the resolution ofportfolio assets. FirstCity’s average investment in wholly owned domesticportfolio assets was $52.4 million and $37.9 million during the second quartersof 2006 and 2005, respectively.

*Interest income from affiliates.*Interest income from affiliates increasedslightly to $.47 million in the second quarter of 2006 from $.45 million in thesecond quarter of 2005.

*Other income.*Otherincome increased to $.4 million in the second quarter of 2006 from $.3 millionin the second quarter of 2005 primarily due to a reduction in the estimatedcarrying value of loans payable to certain members of management by $69,000.

*Expenses.*Operatingexpenses were $5.5 million and $5.0 million in the second quarters of 2006 and2005, respectively.

Interestand fees on notes payable were $1.9 million and $.8 million in the secondquarters of 2006 and 2005, respectively. The average debt for the quarterincreased to $88.5 million in the second quarter of 2006 from $49.8 million inthe second quarter of 2005, and the average cost of borrowing increased from6.8% in 2005 as compared to 8.8% in 2006.

Salariesand benefits decreased 14% to $2.5 million in the second quarter of 2006 from$2.9 million in the second quarter of 2005. The total number of personnelwithin the Portfolio Asset acquisition and resolution segment were 179 and 194at June 30, 2006 and 2005, respectively.

Theprovision (recovery) for loan and impairment losses was minimal from period toperiod.

Occupancy,data processing, communication and other expenses were $1.2 million for thesecond quarter of 2006 and $1.2 million in the second quarter of 2005.

Minorityinterest was minimal from period to period.

23

----

** **

Table of Contents

*Equity inearnings of investments.*Equityin earnings of investments decreased 62.4% to $1.4 million in the secondquarter of 2006 compared to $3.7 million in the second quarter of 2005. Equityearnings in Acquisition Partnerships decreased 66% to $1.1 million in thesecond quarter of 2006 from $3.4 million in the second quarter of 2005.Following is a discussion of equity earnings from Acquisition Partnerships bygeographic region.

·             *Domestic*— Equity in earnings of domestic AcquisitionPartnerships was $1.6 million in the second quarter of 2006 compared to $1.9million in the second quarter of 2005. These partnerships reflected netearnings of $3.4 million in the second quarter of 2006 compared to $4.6 millionin 2005. Income from Portfolio Assets in 2005 was generated primarily fromloans acquired prior to 2005, whereas income in 2006 was generated primarilyfrom loans acquired after 2004. Although collections on Portfolio Assetsincreased to $43.8 million in the second quarter of 2006 from $24.8 million in2005, income from Portfolio Assets acquired after 2004 is less sensitive tocollections than from Portfolio Assets acquired prior to 2005. For Portfoliosacquired after 2004, income is recognized ratably over the remaining life ofthe Portfolio based on an expected yield. For nonperforming loans acquiredprior to 2005, income is recognized to the extent that collections exceed a prorata portion of allocated cost from the pool.

·             *Latin America*— Equity in losses of Acquisition Partnershipslocated in Latin America (primarily Mexico) were $1.6 million in the secondquarter of 2006 compared to equity in earnings of $.4 million in 2005. Thesepartnerships reflected net losses of $16.2 million in the second quarter of2006 compared to net earnings of $2.9 million in 2005. The partnershipsrecorded $14.9 million of foreign exchange losses in the second quarter of 2006compared to $5.1 million of foreign exchange gains in 2005 (of which $1.3million losses and $.4 million gains were included in equity earnings,respectively). During the second quarter of 2006, the partnerships recordedprovisions net of recoveries of allowance for loan losses of $1.9 millioncompared to $1.2 million during the second quarter of 2005. Interest expense of$2.3 million and $2.5 million were recorded in the second quarter of 2006 and2005, respectively. This interest is owed to affiliates of the investors ofthese partnerships, of which FirstCity recorded $.35 million and $.4 million asinterest income in the second quarters of 2006 and 2005, respectively.

·             *Europe*— Equity in earnings of Acquisition Partnershipslocated in Europe remained flat at $1.1 million in the second quarter of 2006compared to $1.1 million in 2005. FirstCity recorded $.3 million and $.3million, respectively, in foreign currency transaction gains (included in otherexpenses) relating to investments in Europe during the second quarter of 2006and 2005.

*Other Items AffectingOperations*

Thefollowing items affect the Company’s overall results of operations and are notdirectly related to the Portfolio Asset acquisition and resolution businessdiscussed above.

*Corporate overhead.   *Corporate overhead expenses remained flat at $1.3million in the second quarter of 2006 compared to $1.3 million in the secondquarter of 2005.

*Income taxes.*Provision for income taxes was $22,000 and $103,000in the second quarters of 2006 and 2005, respectively, and related primarily tostate income taxes. Federal incometaxes are provided at a 35% rate applied to taxable income or loss and areoffset by NOLs that the Company believes are available. The tax benefit of theNOLs is recorded in the period during which the benefit is realized. TheCompany recorded no deferred tax provision in the second quarters of either2006 or 2005.

*Discontinued Operations.*There were no additional losses from discontinued mortgage operationsduring the second quarter of 2006 compared to $94,000 in the second quarter of2005. At June 30, 2006, the only asset remaining from discontinuedmortgage operations is an investment security resulting from the retention of aresidual interest in a securitization transaction. This security is in “run-off,”and the Company is contractually obligated to service the underlying assets.The assumptions used in the valuation model consider both industry as well asthe Company’s historical experience. As the security “runs off,” assumptionsare reviewed in light of historical evidence in revising the prospectiveresults of the model. These revised assumptions could potentially result ineither an increase or decrease in the estimated cash receipts. An additionalprovision is booked based on the output of the valuation model if deemednecessary.

***First Six Months of 2006 Compared to First Six Months of 2005***

TheCompany reported earnings from continuing operations of $3.4 million in thefirst six months of 2006 compared to $5.4 for the same period of 2005. Net earningsto common stockholders were $3.3 million in the first six months of 2006compared to $5.3 

24

----

** **

Table of Contents

million in the first six months of 2005. On a pershare basis, diluted net earnings to common stockholders were $.27 in the firstsix months of 2006 compared to $.44 in the first six months of 2005.

*Portfolio Asset Acquisitionand Resolution*

Theoperating contribution in the first six months of 2006 was $5.9 millioncompared to $8.2 million for the same period last year. FirstCity purchased$67.5 million of Portfolio Assets during the first six months of 2006 ($42million through Acquisition Partnerships), compared to $30.9 million inacquisitions in the first six months of 2005. FirstCity’s investment in theseacquisitions was $42.3 million and $18.3 million in the first six months of2006 and 2005, respectively. FirstCity’s investment in wholly-owned PortfolioAssets increased to $58 million from $43.9 million at June 30, 2006 and2005, respectively.

*Servicing fee revenues.*Servicing fee revenues decreased 9.5% to $5.5 million in the first sixmonths of 2006 from $6.1 million in the first six months of 2005. Service feesfrom the Mexican partnerships decreased by $.6 million, or 14%, as a result ofefforts to reduce operating costs in Mexico. For the Mexican AcquisitionPartnerships, FirstCity earns a servicing fee based on costs of servicing plusa profit margin. Service fees from the domestic Acquisition Partnershipsremained flat at $2.0 million in the first six months of 2006 compared to $2.0million in the same period in 2005.

*Income from Portfolio Assets.*Income from Portfolio Assets increased 21% to $5.0 million in the firstsix months of 2006 compared to $4.1 million in the first six months of 2005,primarily due to increased purchases of portfolio assets. FirstCity’s averageinvestment in wholly-owned domestic portfolio assets was $50.2 million and$37.0 million during the first six months of 2006 and 2005, respectively.

*Interest income from affiliates.*Interest income from affiliates remained flat at$.9 million in the first six months of 2006 and $.9 million in the first sixmonths of 2005.

*Other income.*Other income was $.9 million in the first six months of 2006 compared to$.6 million in 2005, primarily due to a reduction in the estimated carryingvalue of loans payable to certain members of management by $.1 million.

*Expenses.*Operatingexpenses were $11.3 million in the first six months of 2006 compared to $10.4million in the first six months of 2005.

Interest and fees onnotes payable increased to $3.7 million inthe first six months of 2006 from $1.7 million in the first six months of 2005. The average debt for the periodincreased to $87.5 million in the first six months of 2006 from $50.2 millionin the first six months of 2005, and the average cost of borrowing increased to8.35% in 2006 from 6.9% in 2005.

Salariesand benefits decreased to $5.4 million in the first six months of 2006 from $6.2million in the first six months of 2005. Total personnel within the PortfolioAsset acquisition and resolution segment were 179 and 194 at June 30, 2006and 2005, respectively.

Theprovision for loan and impairment losses was $51,000 in the first six months of2006 compared to $114,000 in 2005.

Occupancy,data processing, communication and other expenses decreased slightly to $2.2million in the first six months of 2006 compared to $2.3 million in the firstsix months of 2005.

*Equity in earnings of investments.*Equity in earnings of investments decreased 29%to $5.0 million in the first six months of 2006 compared to $7.1 million in thefirst six months of 2005. Equity earnings in Acquisition Partnerships decreased25% to $4.8 million in the first six months of 2006 from $6.4 million in thefirst six months of 2005. Equity in earnings of servicing entities decreased70% to $.2 million in the first six months of 2006 from $.7 million in thefirst six months of 2005. Following is a discussion of equity earnings inAcquisition Partnerships by geographic region. See note 6 to the consolidatedfinancial statements for a summary of revenues and earnings of the AcquisitionPartnerships and equity in earnings of the Acquisition Partnerships.

·             *Domestic*— Equity in earnings of domesticAcquisition Partnerships decreased 9% to $3.9 million in the first six monthsof 2006 from $4.2 million in the first six months of 2005 primarily as a resultof timing. These partnerships reflected netearnings of $8.0 million in the first six months of 2006 compared to $10.2million in the first six months of 2005. Income from Portfolio Assets in 2005was generated primarily from loans acquired prior to 2005, whereas income in2006 was generated primarily from loans acquired after 2004. Althoughcollections on Portfolio Assets increased to $67.1 million in the first six 

25

----

** **

Table of Contents

monthsof 2006 from $52.2 million in the first six months of 2005, income from PortfolioAssets acquired after 2004 is less sensitive to collections than from PortfolioAssets acquired prior to 2005. For Portfolios acquired after 2004, income isrecognized ratably over the remaining life of the Portfolio based on anexpected yield. For nonperforming loans acquired prior to 2005, income isrecognized to the extent that collections exceed a pro rata portion ofallocated cost from the pool.

·             *Latin America*— Equity in losses of Latin American AcquisitionPartnerships were $1.1 million in the first six months of 2006 compared to $.2million equity earnings in 2005. These partnerships reflected losses of $12.3million in the first six months of 2006 compared to earnings of $2.7 million in2005. Although the revenues were higher for the period, the partnershipsrecorded foreign exchange losses of $13.2 million in the first six months of2006 compared to gains of $9.1 million in 2005 (of which $1.1 million lossesand $.72 million gains are included in equity earnings, respectively). Inaddition, provisions net of recoveries of allowance for loan losses of $.54million were recorded in the first six months of 2006 compared to $1.3 millionfor the same period in 2005. Interest expense of $4.4 million and $5.6 millionwere recorded during the first six months of 2006 and 2005, respectively. Thisinterest is owed to the investors of these partnerships, of which FirstCityrecorded $.7 million in 2006 and 2005 as interest income.

·             *Europe*— Equity in earnings of Acquisition Partnershipslocated in Europe was $2.1 million in the first six months of 2006 compared to$2.0 million in 2005. During the first six months of 2006 and 2005, FirstCityalso recorded $.7 million and $.5 million, respectively, in foreign currencytransaction gains (included in other expenses) relating to investments in Europe.

### *Other ItemsAffecting Operations*

Thefollowing items affect the Company’s overall results of operations and are notdirectly related to the Company’s Portfolio Asset acquisition and resolutionbusiness discussed above.

*Corporate interest and overhead.*Corporate overhead expenses decreased 12% to $2.5million in the first six months of 2006 from $2.9 million in the first sixmonths of 2005, primarily due to decreased salaries and legal and accountingfees.

*Income taxes.*Provision for income taxes was $.1 million in thefirst six months of 2006 compared to $.2 million in the first six months of2005 and related primarily to state income taxes. Federal income taxes are provided at a 35% rateapplied to taxable income or loss and are offset by NOLs that the Companybelieves are available. The tax benefit of the NOLs is recorded in the periodduring which the benefit is realized. The Company recorded no deferred taxprovision in either of the first six months of 2006 or 2005.

*Discontinued Operations.*Discontinued operations includes an impairment provision of $58,000 inthe first six months of 2006 compared to $78,000 in the first six months of2005. At June 30, 2006, the only asset remaining from discontinued mortgageoperations is an investment security resulting from the retention of a residualinterest in a securitization transaction. This security is in “run-off,” andthe Company is contractually obligated to service the underlying assets. Theassumptions used in the valuation model consider both industry as well as theCompany’s historical experience. As the security “runs off,” assumptions arereviewed in light of historical evidence in revising the prospective results ofthe model. These revised assumptions could potentially result in either anincrease or decrease in the estimated cash receipts. An additional provision isbooked based on the output of the valuation model if deemed necessary.

26

----

** **

Table of Contents

#### **FinancialCondition**

Majorchanges in FirstCity’s financial condition resulted from the following.

Consolidatedassets of $190.6 million at June 30, 2006, were $4.3 million lower thanthat at December 31, 2005. Portfolio Assets increased by $8.7 million withacquisitions made during 2006. Loans Receivable from Acquisition Partnershipsheld for investment increased by $6.2 million. In May 2006, FirstCity andCargill bought out the loan and equity interest in the Mexican Partnershipsthat were owned by the other investors in those Partnerships. Equityinvestments declined $15.8 million primarily due to the refinancing of debt bytwo Acquisition Partnerships, which distributed the excess funds to the owners.The Company used the distribution from the refinancing to pay down corporatedebt.

Consolidatedliabilities of $87.7 million as of June 30, 2006, were $8.2 million lowerthan that at December 31, 2005. Total notes payable decreased by $8million and reflected advances of $57.3 million primarily for portfolioacquisitions, net of repayments of $66.4 million. Minority interest increasedto $ 2.1 million as of June 30, 2006, from $1.2 million in December 31,2005, due to the purchase of one portfolio during the first quarter which had a20% minority interest.

#### **PortfolioAsset Acquisition and Resolution**

Aggregate acquisitions by theCompany are as follows (in thousands):

|                           | ** ** | **   Purchase   ** | ** ** | **FirstCity**  | ** ** |
|---------------------------|------------|--------------------------------------------------|------------|----------------|------------|
| ** **                | ** ** | **Price**                                        | ** ** | **Investment** | ** ** |
| First six months of  2006 |       | $                                                | 67,553     |           | $          | 42,278 |   |
| Total 2005                |       | 146,581                                          |       | 71,405         |       |
| Total 2004                |       | 174,139                                          |       | 59,762         |       |
| Total 2003                |       | 129,192                                          |       | 22,944         |       |
| Total 2002                |       | 171,769                                          |       | 16,717         |       |
| Total 2001                |       | 224,927                                          |       | 24,319         |       |
|                           |            |                                                  |            |                |            |  |  |

The following table presentsselected information regarding the revenues and expenses of the Company’s PortfolioAsset acquisition and resolution business (in thousands):

27

----

** **

Table of Contents

**Analysis of Selected Revenues and Expenses**

**Portfolio AssetAcquisition and Resolution**

 
| ** **                                                    | ** ** | **Three Months Ended**                                                 | ** ** | **Six Months Ended**                                                   | ** ** |
|---------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                                                    | ** ** | **June 30,**                                                                | ** ** | **June 30,**                                                                | ** ** |
| ** **                                                    | ** ** | **      2006      ** | ** ** | **      2005      ** | ** ** | **      2006      ** | ** ** | **      2005      ** | ** ** |
| **Portfolio Assets and Loans  Receivable:**                   |       |                                                                             |       |                                                                             |       |   |   |   |   |
| Average  investment in Portfolio Assets and loans receivable: |       |                                                                             |       |                                                                             |       |   |   |   |   |
| Domestic                                                      |       | $                                                                                | 54,439     |                                                                             | $          | 39,570 |   | $ | 52,112 |   | $ | 38,620 |   |
| Latin America                                                 |       | 18,803                                                                           |       | 18,909                                                                           |       | 17,617 |   | 18,947 |   |
| Europe                                                        |       | 1,969                                                                            |       | 505                                                                              |       | 1,864 |   | 517 |   |
| Total                                                         |       | $                                                                                | 75,211     |                                                                             | $          | 58,984 |   | $ | 71,593 |   | $ | 58,084 |   |
| Income from  Portfolio Assets and loans receivable:           |       |                                                                             |       |                                                                             |       |   |   |   |   |
| Domestic                                                      |       | $                                                                                | 3,027      |                                                                             | $          | 1,863 |   | $ | 5,157 |   | $ | 4,256 |   |
| Latin America                                                 |       | 348                                                                              |       | 384                                                                              |       | 679 |   | 747 |   |
| Europe                                                        |       | 36                                                                               |       | 7                                                                                |       | 63 |   | 15 |   |
| Total                                                         |       | $                                                                                | 3,411      |                                                                             | $          | 2,254 |   | $ | 5,899 |   | $ | 5,018 |   |
| Average return  (annualized):                                 |       |                                                                             |       |                                                                             |       |   |   |   |   |
| Domestic                                                      |       | 22.2                                                                             | %          | 18.8                                                                             | %          | 19.8 | % | 22.0 | % |
| Latin America                                                 |       | 7.4                                                                              | %          | 8.1                                                                              | %          | 7.7 | % | 7.9 | % |
| Europe                                                        |       | 7.3                                                                              | %          | 5.5                                                                              | %          | 6.8 | % | 5.8 | % |
| Total                                                         |       | 18.1                                                                             | %          | 15.3                                                                             | %          | 16.5 | % | 17.3 | % |
| **Servicing fee revenues:**                                   |       |                                                                             |       |                                                                             |       |   |   |   |   |
| Domestic  partnerships:                                       |       |                                                                             |       |                                                                             |       |   |   |   |   |
| Servicing fee  revenue                                        |       | $                                                                                | 1,214      |                                                                             | $          | 833 |   | $ | 1,973 |   | $ | 1,974 |   |
| Average  servicing fee %                                      |       | 2.8                                                                              | %          | 3.4                                                                              | %          | 2.9 | % | 3.8 | % |
| Latin American  partnerships:                                 |       |                                                                             |       |                                                                             |       |   |   |   |   |
| Servicing fee  revenue                                        |       | $                                                                                | 1,534      |                                                                             | $          | 1,915 |   | $ | 3,360 |   | $ | 3,896 |   |
| Average  servicing fee %                                      |       | 9.0                                                                              | %          | 8.2                                                                              | %          | 11.5 | % | 11.4 | % |
| Incentive  service fees                                       |       | $                                                                                | 108        |                                                                             | $          | 161 |   | $ | 170 |   | $ | 211 |   |
| Total Service  Fees:                                          |       |                                                                             |       |                                                                             |       |   |   |   |   |
| Servicing fee  revenue                                        |       | 2,856                                                                            |       | 2,909                                                                            |       | 5,503 |   | 6,081 |   |
| Average  servicing fee %                                      |       | 4.7                                                                              | %          | 6.1                                                                              | %          | 5.7 | % | 7.0 | % |
| **Collections:**                                              |       |                                                                             |       |                                                                             |       |   |   |   |   |
| Domestic                                                      |       | $                                                                                | 43,840     |                                                                             | $          | 24,793 |   | $ | 67,109 |   | $ | 52,227 |   |
| Latin America                                                 |       | 17,059                                                                           |       | 23,277                                                                           |       | 29,204 |   | 34,174 |   |
| Europe                                                        |       | 12,418                                                                           |       | 15,788                                                                           |       | 29,115 |   | 28,986 |   |
| Subtotal                                                      |       | 73,317                                                                           |       | 63,858                                                                           |       | 125,428 |   | 115,387 |   |
| Wholly owned:                                                 |       | 15,416                                                                           |       | 5,593                                                                            |       | 22,147 |   | 13,931 |   |
| Total                                                         |       | $                                                                                | 88,733     |                                                                             | $          | 69,451 |   | $ | 147,575 |   | $ | 129,318 |   |
| **Personnel:**                                                | ** ** | ** **                                                                       | ** ** | ** **                                                                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| Personnel  expenses                                           |       | $                                                                                | 2,504      |                                                                             | $          | 2,918 |   | $ | 5,437 |   | $ | 6,187 |   |
| Number of  personnel (at period end):                         |       |                                                                             |       |                                                                             |       |   |   |   |   |
| Domestic                                                      |       | 61                                                                               |       | 66                                                                               |       |   |   |   |   |
| Latin America                                                 |       | 118                                                                              |       | 128                                                                              |       |   |   |   |   |
| Subtotal                                                      |       | 179                                                                              |       | 194                                                                              |       |   |   |   |   |
| Corporate                                                     |       | 33                                                                               |       | 34                                                                               |       |   |   |   |   |
| Total                                                         |       | 212                                                                              |       | 228                                                                              |       |   |   |   |   |
| **Interest expense:**                                         |       |                                                                             |       |                                                                             |       |   |   |   |   |
| Average debt                                                  |       | $                                                                                | 88,525     |                                                                             | $          | 49,810 |   | $ | 87,515 |   | $ | 50,242 |   |
| Interest expense                                              |       | 1,948                                                                            |       | 848                                                                              |       | 3,656 |   | 1,728 |   |
| Average cost  (annualized)                                    |       | 8.8                                                                              | %          | 6.8                                                                              | %          | 8.4 | % | 6.9 | % |
| **Provision (recovery) for  impairment on Portfolio Assets:** |       |                                                                             |       |                                                                             |       |   |   |   |   |
| Non-performing                                                |       | $                                                                                | 6          |                                                                             | $          | — |   | $ | 17 |   | $ | — |   |
| Performing                                                    |       | (90                                                                              | )          | 29                                                                               |       | 4 |   | 114 |   |
| Real estate                                                   |       | —                                                                           |       | —                                                                           |       | 2 |   | — |   |
| Loans acquired  after 2004 with credit deterioration          |       | 6                                                                                |       | —                                                                           |       | 8 |   | — |   |
| Loans acquired after  2004 with no credit deterioration       |       | 20                                                                               |       | —                                                                           |       | 20 |   | — |   |
|                                                          |       | $                                                                                | (58        | )                                                                                | $          | 29 |   | $ | 51 |   | $ | 114 |   |

 

28

----

** **

Table of Contents

The following table presents selected informationregarding the revenues and expenses of the Acquisition Partnerships (dollars inthousands):

**Analysis of SelectedRevenues and Expenses**

**Acquisition Partnerships**

 

|                                                            | ** ** | **Three Months Ended**                                     | ** ** | **Six Months Ended**                                       | ** ** |
|------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                                 | ** ** | **June 30,**                                                    | ** ** | **June 30,**                                                    | ** ** |
| ** **                                                 | ** ** | **     2006     ** | ** ** | **     2005     ** | ** ** | **     2006     ** | ** ** | **     2005     ** | ** ** |
| Revenues:                                                  |       |                                                                 |       |                                                                 |       |   |   |   |   |
| Gain on  resolution of Portfolio Assets                    |       | $                                                                    | 15,242     |                                                                 | $          | 25,650 |   | $ | 30,284 |   | $ | 45,814 |   |
| Gross profit  percentage on resolution of Portfolio Assets |       | 33.82                                                                | %          | 40.68                                                                | %          | 39.21 | % | 42.15 | % |
| Interest income                                            |       | $                                                                    | 4,250      |                                                                 | $          | 2,649 |   | $ | 8,222 |   | $ | 4,755 |   |
| Other income                                               |       | 366                                                                  |       | 136                                                                  |       | 1,521 |   | 369 |   |
| Interest expense (1):                                      |       |                                                                 |       |                                                                 |       |   |   |   |   |
| Interest expense                                           |       | $                                                                    | 3,328      |                                                                 | $          | 3,773 |   | $ | 6,308 |   | $ | 8,177 |   |
| Average cost  (annualized)                                 |       | 4.83                                                                 | %          | 4.68                                                                 | %          | 4.63 | % | 5.00 | % |
| Other expenses:                                            |       |                                                                 |       |                                                                 |       |   |   |   |   |
| Service fees                                               |       | $                                                                    | 3,986      |                                                                 | $          | 4,237 |   | $ | 7,195 |   | 9,387 |   |
| Other operating  costs                                     |       | 6,550                                                                |       | 13,277                                                               |       | 9,239 |   | 20,742 |   |
| Foreign currency  (gains) losses                           |       | 14,873                                                               |       | (5,066                                                               | )          | 13,218 |   | (9,075 | ) |
| Income taxes                                               |       | 235                                                                  |       | 340                                                                  |       | 360 |   | 801 |   |
| Total other  expenses                                      |       | 25,644                                                               |       | 12,788                                                               |       | 30,012 |   | 21,855 |   |
| Net earnings                                               |       | $                                                                    | (9,114     | )                                                                    | $          | 11,874 |   | $ | 3,707 |   | $ | 20,906 |   |
| Equity in earnings of  Acquisition Partnerships            |       | $                                                                    | 1,128      |                                                                 | $          | 3,362 |   | $ | 4,819 |   | $ | 6,410 |   |
| Equity in earnings of  Servicing Entities                  |       | 259                                                                  |       | 328                                                                  |       | 202 |   | 681 |   |
| Equity in earnings of  investments                         |       | $                                                                    | 1,387      |                                                                 | $          | 3,690 |   | $ | 5,021 |   | $ | 7,091 |   |

----

(1)          Interest expense includes interest on loans to the AcquisitionPartnerships located primarily in Mexico from affiliates of the investorgroups. Beginning in 2003, FirstCity amended seven loan agreements from MexicanAcquisition Partnerships to provide for no interest to be payable with respectto periods after the effective date of the amendment. This change had no impacton the consolidated net earnings as the effect is offset through equityearnings in these Partnerships.

 

**Analysis of EquityInvestments in Acquisition Partnerships(dollars in thousands)**

 

|                                                                 | ** ** | **Three Months Ended**                                     | ** ** | **Six Months Ended**                                       | ** ** |
|-----------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                                      | ** ** | **June 30,**                                                    | ** ** | **June 30,**                                                    | ** ** |
| ** **                                                      | ** ** | **     2006     ** | ** ** | **     2005     ** | ** ** | **     2006     ** | ** ** | **     2005     ** | ** ** |
| **FirstCity's Average investment  in Acquisition Partnerships** |       |                                                                 |       |                                                                 |       |   |   |   |   |
| Domestic                                                        |       | $                                                                    | 51,054     |                                                                 | $          | 35,561 |   | $ | 51,678 |   | $ | 35,969 |   |
| Latin America                                                   |       | 3,094                                                                |       | 1,477                                                                |       | 2,977 |   | 1,486 |   |
| Europe                                                          |       | 19,065                                                               |       | 12,253                                                               |       | 19,390 |   | 12,428 |   |
| Europe-Servicing  subsidiaries                                  |       | 5,455                                                                |       | 6,260                                                                |       | 5,512 |   | 6,139 |   |
| Latin  America-Servicing subsidiaries                           |       | 190                                                                  |       | 301                                                                  |       | 227 |   | 172 |   |
| Total                                                           |       | $                                                                    | 78,858     |                                                                 | $          | 55,852 |   | $ | 79,784 |   | $ | 56,194 |   |
|                                                            |       |                                                                 |       |                                                                 |       |   |   |   |   |
| **FirstCity share of equity  earnings (loss)**                  |       |                                                                 |       |                                                                 |       |   |   |   |   |
| Domestic                                                        |       | $                                                                    | 1,585      |                                                                 | $          | 1,911 |   | $ | 3,854 |   | $ | 4,224 |   |
| Latin America                                                   |       | (1,575                                                               | )          | 365                                                                  |       | (1,131 | ) | 191 |   |
| Europe                                                          |       | 1,118                                                                |       | 1,086                                                                |       | 2,096 |   | 1,995 |   |
| Europe-Servicing  subsidiaries                                  |       | 292                                                                  |       | 226                                                                  |       | 366 |   | 402 |   |
| Latin  America-Servicing subsidiaries                           |       | (33                                                                  | )          | 102                                                                  |       | (164 | ) | 279 |   |
| Total                                                           |       | $                                                                    | 1,387      |                                                                 | $          | 3,690 |   | $ | 5,021 |   | $ | 7,091 |   |

 

29

----

** **

Table of Contents

**Provision for Income Taxes**

TheCompany has substantial NOLs, which can be used to offset the tax liabilityassociated with the Company’s pre-tax earnings until the earlier of theexpiration or utilization of such NOLs. The Company accounts for the benefit ofthe NOLs by recording the benefit as an asset and then establishing a valuationallowance to value the net deferred tax asset at a level, which more likelythan not, will be realized. Realization is determined based on management’sexpectation of generating sufficient taxable income in a look forward periodover the next four years. The ultimate realization of the resulting netdeferred tax asset is dependent upon generating sufficient taxable income fromits continuing operations prior to expiration of the NOLs. Although realizationis not assured, management believes it is more likely than not that all of therecorded deferred tax asset, net of the allowance, will be realized. The amountof the deferred tax asset considered realizable, however, could be adjusted inthe future if estimates of future taxable income during the carryforward periodchange. The ability of the Company to realize the deferred tax asset isperiodically reviewed and the valuation allowance is adjusted accordingly.

**Liquidityand Capital Resources**

Generally, the Company requires liquidity to fund itsoperations, working capital, payment of debt, equity for acquisition ofPortfolio Assets, investments in and advances to the Acquisition Partnerships,and other investments by the Company. The potential sources of liquidity arefunds generated from operations, equity distributions from the AcquisitionPartnerships, interest and principal payments on subordinated intercompany debtand dividends from the Company’s subsidiaries, borrowings from revolving linesof credit, proceeds from equity market transactions, securitization and otherstructured finance transactions and other special purpose short-termborrowings.

FirstCity has a $92 million revolving acquisitionfacility with Bank of Scotland that matures in November 2008. Thisfacility is used to finance the equity portion of distressed asset poolpurchases and to provide for the issuance of Letters of Credit and workingcapital loans. This facility (i) allows loans to be made in Euros up to amaximum amount in Euros that is equivalent to 35 million U.S. dollars, (ii) allowsloans to be made for acquisition of Portfolio Assets originated in LatinAmerica of up to $35 million, (iii) provides for an interest rate of LIBORplus 2.50% to 2.75%, (iv) provides for an annual commitment fee of 0.20%of the average daily unused balance of the revolving acquisition facility, (v) providesthat the aggregate borrowings under the facility does not exceed 60% of the netpresent value of FirstCity’s interest in Portfolio Assets and in AcquisitionPartnerships pledged to secure the acquisition facility, and (vi) providesfor a reduction in the total loan commitment of $1.3 million per quarter,commencing on December 27, 2005.

In August 2005, FH Partners, L.P., an indirectwholly-owned affiliate of FirstCity, and Bank of Scotland, acting through itsNew York branch, as agent for itself as lender, entered into a Revolving CreditAgreement that provides for a $50 million revolving Portfolio acquisitionfacility for FH Partners, L.P. to be secured by all of the assets of FHPartners, L.P. The loan facility will be used to finance Portfolio and assetpurchases. The facility (i) allows loans to be made for the acquisition ofPortfolio Assets in the United States, (ii) provides that each loan may bein an amount of up to 70% of the net present value of the assets being acquiredwith the proceeds of the loan, (iii) provides that the aggregateoutstanding balances of all loans will not exceed 65% of the net present valueof the assets securing the loan facility, (iv) provides for an interestrate of LIBOR plus 2.0%, (v) provides for an annual commitment fee of0.20% of the average daily unused balance of the revolving acquisitionfacility, (vi) provides for a utilization fee of 0.75% of the amount ofeach loan made under the loan facility, (vii) provides for an upfront feeof $350,000, (viii) provides for facility fees of $100,000, for the periodcommencing on the Effective Date and ending the day before the firstanniversary thereof, $75 thousand, for the period commencing on the firstanniversary of the Effective Date and ending the day before the secondanniversary thereof, and $50 thousand, for each subsequent one-year period, and(ix) provides for a maturity date of November 12, 2008. Theobligations of FH Partners, L.P. under the Revolving Credit Agreement areguaranteed by FirstCity and the primary wholly-owned subsidiaries of FirstCity.

BoS (USA) has a warrant to purchase 425,000 shares ofthe Company’s voting Common Stock at $2.3125 per share. BoS (USA) is entitledto additional warrants in connection with this existing warrant for 425,000shares under certain specific situations to retain its ability to acquireapproximately 4.86% of the Company’s voting Common Stock. The warrant willexpire on August 31, 2010, if it is not exercised prior to that date.

Excluding the term acquisition facilities of theunconsolidated Acquisition Partnerships, as of June 30, 2006, the Companyand its subsidiaries had credit facilities providing for borrowings in anaggregate principal amount of $146 million and outstanding borrowings of $82million.

30

----

** **

Table of Contents

Management believes that the Bank of Scotlandfacilities, the related fees generated from the servicing of assets, equitydistributions from existing Acquisition Partnerships and wholly-ownedportfolios, as well as sales of interests in equity investments, will allow theCompany to meet its obligations as they come due during the next twelve months.

The following table summarizes the material terms ofthe credit facilities to which the Company, its major operating subsidiariesand the Acquisition Partnerships were parties to as of August 9, 2006, andthe outstanding borrowings under such facilities as of June 30, 2006.

**Credit Facilities**

 
| ** **                                                                           | ** **   | **Funded and**            | ** ** | ** **      | ** ** | ** **                                 | ** ** | ** **                                                                                   |
|--------------------------------------------------------------------------------------|--------------|---------------------------|------------|-----------------|------------|--------------------------------------------|------------|----------------------------------------------------------------------------------------------|
| ** **                                                                           | ** **   | **Unfunded**              | ** ** | **Outstanding** | ** ** | ** **                                 | ** ** | ** **                                                                                   |
| ** **                                                                           | ** **   | **Commitment**            | ** ** | **Borrowings**  | ** ** | ** **                                 | ** ** | ** **                                                                                   |
| ** **                                                                           | ** **   | **Amount as of**          | ** ** | **as of**       | ** ** | ** **                                 | ** ** | ** **                                                                                   |
| ** **                                                                           | ** **   | **August 9,**             | ** ** | **June 30,**    | ** ** | ** **                                 | ** ** | ** **                                                                                   |
| ** **                                                                           | ** **   | **2006**                  | ** ** | **2006**        | ** ** | **Interest Rate**                          | ** ** | **Other Terms and Conditions**                                                               |
| ** **                                                                           | ** **   | **(Dollars in millions)** | ** ** | ** **      | ** ** | ** **                                 |
|                                                                                 |         |                      |       |            |       |                                       |       |                                                                                         |
| Bank of Scotland  $92 million portfolio acquisition and working capital facility (1) |         | $                         | 92         |            | $          | 57                                         |       | LIBOR + 2.5% - 2.75%                                                                         |   | Secured by equity interests and other assets of  FirstCity, matures November 2008 |
|                                                                                 |         |                      |       |            |       |                                       |       |                                                                                         |
| Bank of Scotland  $50 million portfolio acquisition - revolving credit               |         | 50                        |       | 21              |       | LIBOR + 2.0%                               |       | Secured by assets of FH Partners, L.P. and  guaranteed by the Company, matures November 2008 |
|                                                                                 |         |                      |       |            |       |                                       |       |                                                                                         |
| American Bank  term loan for portfolio acquisition by FC Washington                  |         | 3                         |       | 3               |       | Fixed 5.625%                               |       | Secured by assets of FC Washington and guaranteed by  the Company, matures 2008              |
|                                                                                 |         |                      |       |            |       |                                       |       |                                                                                         |
| Unsecured loans  payable to senior management                                        |         | —                    |       | —          |       | Rate based Corporate average cost of funds |       | Contingent liability related to acquisition of minority  interest, matures December 2011     |
|                                                                                 | *** *** | *** ***              |       |            |       |                                       |       |                                                                                         |
| Participation  payable                                                               |         | 1                         |       | 1               |       | 15% imputed rate                           |       | Participation agreement on 33% of net cash flows  received on one portfolio                  |
|                                                                                 |         |                      |       |            |       |                                       |       |                                                                                         |
| Total                                                                                |         | $                         | 146        |            | $          | 82                                         |       |                                                                                         |   |   |
|                                                                                 |         |                      |       |            |       |                                       |       |                                                                                         |
| Unconsolidated  Acquisition Partnerships Term Facilities (2)                         |         | $                         | 79         |            | $          | 79                                         |       | Various rates                                                                                |   | Secured by Portfolio Assets, various maturities non-recourse |

----

(1)          The Bankof Scotland facility allows loans to be made in Euros up to a maximum amount inEuros that is equivalent to $35 million. At June 30, 2006, the Company hadapproximately $16.4 million outstanding under the Euro-denominated portion ofthis facility.

(2)          Inaddition to the term acquisition facilities of the unconsolidated AcquisitionPartnerships, the Latin American Acquisition Partnerships also have term debtof approximately $200.8 million outstanding as of June 30, 2006, owed toaffiliates of the investor groups. Of this amount, the Company has recordedapproximately $21.7 million as Loans Receivable on the Consolidated BalanceSheets.

31

----

** **

Table of Contents

**Forward-Looking Statements**

Certainstatements contained in this Quarterly Report on Form 10-Q orincorporated by reference from time to time, including, but not limited to,statements relating to the Company’s strategic objectives and futureperformance, which are not historical facts, may be deemed to beforward-looking statements under the Private Securities Litigation Reform Actof 1995. Forward-looking statements include, without limitation, any statementthat may project, indicate or imply future results, performance orachievements, and may contain the words “expect,” “intend,” “plan,” “estimate,”“believe,” “will be,” “will continue,” “will likely result,” and similarexpressions. Such statements inherently are subject to a variety of risks anduncertainties that could cause actual results to differ materially from thoseprojected. There are many important factors that could cause the Company’sactual results to differ materially from those indicated in the forward-lookingstatements. Such factors include, but are not limited to, risks associated withforeign operations; currency exchange rate fluctuations; the performance of theCompany’s subsidiaries and affiliates; the availability of Portfolio Assets;assumptions underlying Portfolio asset performance; interest rate risk; thedegree to which the Company is leveraged; the Company’s continued need forfinancing; availability of the Company’s credit facilities; the impact ofcertain covenants in loan agreements of the Company and its subsidiaries; risksof declining value of loans, collateral or assets; the ability of the Companyto utilize NOLs; uncertainties of any litigation that might arise fromdiscontinued operations; general economic conditions; foreign social andeconomic conditions; changes (legislative and otherwise) in the assetsecuritization industry; fluctuations in residential and commercial real estatevalues; capital market conditions, including the markets for asset-backedsecurities; factors more fully discussed and identified in the Company’s AnnualReport on Form 10-K, for the year ended December 31, 2005(including those discussed under “Item 7. Management’s Discussion and Analysisof Financial Condition and Results of Operations”), as well as in otherSecurities and Exchange Commission filings of the Company. Many of thesefactors are beyond the Company’s control. In addition, it should be noted thatpast financial and operational performance of the Company is not necessarilyindicative of future financial and operational performance. Given these risksand uncertainties, investors should not place undue reliance on forward-lookingstatements. The forward-looking statements in this Quarterly Report on Form 10-Qspeak only as of the date of this Quarterly Report on Form 10-Q. TheCompany expressly disclaims any obligation or undertaking to release publiclyany updates or revisions to any forward-looking statement to reflect any changein the Company’s expectations with regard thereto or any change in events,conditions or circumstances on which any forward-looking statement is based.

**Item 3. Quantitative and Qualitative Disclosures About Market Risk.**

Market risk is the risk of loss from adverse changesin market prices and interest rates. The Company’s operations are materiallyimpacted by net gains on sales of loans and net interest margins. The level ofgains from loan sales the Company achieves is dependent on demand for theproducts originated. Net interest margins are dependent on the Company’sability to maintain the spread or interest differential between the interest itcharges the customer for loans and the interest the Company is charged for thefinancing of those loans. The following describes each component of interestbearing assets held by the Company and how each could be affected by changes ininterest rates.

The Company invests in Portfolio Assets both directlythrough consolidated subsidiaries and indirectly through equity investments inAcquisition Partnerships. Portfolio Assets consist of investments in pools ofnon-homogenous assets that predominantly consist of loan and real estateassets. Earnings from these assets are based on the estimated future cash flowsfrom such assets and recorded when those cash flows occur. The underlying loanswithin these pools bear both fixed and variable rates. Due to thenon-performing nature and history of these loans, changes in prevailingbenchmark rates (such as the prime rate or LIBOR) generally have a nominaleffect on the ultimate future cash flow to be realized from the loan assets.Furthermore, these pools of assets are held for sale, not for investment;therefore, the disposition strategy is to liquidate these assets as quickly aspossible.

Loans receivable consist of investment loans made toAcquisition Partnerships and bear interest at predominately fixed rates. Thecollectibility of these loans is directly related to the underlying PortfolioAssets of those Acquisition Partnerships, which are non-performing in nature.Therefore, changes in benchmark rates would have minimal effect on thecollectibility of these loans.

The Company currently has investments in Europe andLatin America (i.e. Mexico, Argentina, Dominican Republic and Chile). In Europe,the Company’s investments are in the form of equity and represent a significantportion of the Company’s total equity investments. As of June 30, 2006,one U.S. dollar equaled .80 Euros. A sharp change in the Euro relative to theU.S. dollar could materially adversely affect the financial position andresults of operations of the Company. A 5% and 10% incremental depreciation ofthe Euro would result in an estimated decline in the valuation of the Company’sequity investments in Europe of approximately $1.3 million and $2.4 million,respectively. These amounts are estimates of the financial impact of adepreciation of the Euro relative to the U.S. dollar. Consequently, theseamounts are not necessarily indicative of the actual effect of such changeswith respect to the Company’s consolidated financial position or results ofoperations. As discussed above, the revolving acquisition facility with Bank of

32

----

** **

Table of Contents

Scotland for $92million allows loans to be made in Euros up to a maximum amount in Euros thatis equivalent to $35 million U.S. dollars. At June 30, 2006, the Companyheld $16.4 million in Euro-denominated debt for the purpose of hedging aportion of the net equity investments in Europe. Management of the Companyfeels that this loan agreement will help reduce the risk of adverse effects ofcurrency changes on Euro-denominated investments.

In Mexico, approximately 95% of the Company’sinvestments are made through U.S. dollar denominated loans to the Partnershipslocated in Mexico. The remaining investment is in the form of equity in thesesame Partnerships. The loans receivable are required to be repaid in U.S.dollars. Although the U.S. dollar balance of these loans will not change due toa change in the Mexican peso, the future estimated cash flows of the underlyingassets in Mexico could become less valuable as a result of a change in theexchange rate for the Mexican peso, and thus, could affect the overall totalreturns to the Company on these investments. As of June 30, 2006, one U.S.dollar equaled 11.40 Mexican pesos. A 5% and 10% incremental depreciation ofthe Mexican peso would result in an estimated decline in the valuation of theCompany’s total investments in Mexico of approximately $.9 million and $1.7million, respectively. These amounts are estimates of the financial impact of adepreciation of the Mexican peso relative to the U.S. dollar. Consequently,these amounts are not necessarily indicative of the actual effect of suchchanges with respect to the Company’s consolidated financial position orresults of operations.

FirstCity has loans and equity investments in SouthAmerica—primarily in Argentina Acquisition Partnerships. As of June 30,2006, one U.S. dollar equaled 3.09 Argentine pesos. The Company estimates thata 5% and 10% incremental depreciation of the Argentine peso would result in adecline in the valuation of the Company’s total investments in Argentina ofapproximately $.066 million and $.13 million, respectively. These amounts areestimates of the financial impact of a depreciation of the Argentine pesorelative to the U.S. dollar. Consequently, these amounts are not necessarilyindicative of the actual effect of such changes with respect to the Company’sconsolidated financial position or results of operations.

FirstCity has an equity investment in a DominicanRepublic Acquisition Partnership. As of June 30, 2006, one U.S. dollarequaled 33.83 Dominican Republic pesos. The Company estimates that a 5% and 10%incremental depreciation of the Dominican Republic peso would result in adecline in the valuation of the Company’s total investments in DominicanRepublic of approximately $.037 million and $.071 million, respectively. Theseamounts are estimates of the financial impact of a depreciation of theDominican Republic peso relative to the U.S. dollar. Consequently, theseamounts are not necessarily indicative of the actual effect of such changeswith respect to the Company’s consolidated financial position or results ofoperations.

**Item 4. Controls and Procedures.**

Anevaluation was performed under the supervision and with the participation ofthe Company’s management, including the Company’s Chief Executive Officer andChief Financial Officer, of the effectiveness of the design and operation ofthe Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934) as of June 30,2006. Based on that evaluation, the Chief Executive Officer and Chief FinancialOfficer concluded that the Company’s disclosure controls and procedures wereeffective, in all material respects, to ensure that information required to bedisclosed in the reports the Company files and submits under the Exchange Actis recorded, processed, summarized and reported as and when required. There hasbeen no change in the Company’s internal controls over financial reporting orin other factors that has materially affected, or is reasonably likely toaffect, the registrant’s internal control over financial reporting.

33

----

** **

Table of Contents

**PART II**

**OTHERINFORMATION**

**Item 1. Legal Proceedings.**

Periodically, FirstCity, its subsidiaries, itsaffiliates and the Acquisition Partnerships are parties to or otherwiseinvolved in legal proceedings arising in the normal course of business.FirstCity does not believe that there is any proceeding threatened or pendingagainst it, its subsidiaries, its affiliates or the Acquisition Partnershipswhich, if determined adversely, would have a material adverse effect on theconsolidated financial position, results of operations or liquidity ofFirstCity, its subsidiaries, its affiliates or the Acquisition Partnerships.

On January 19, 2005,Prudential Financial, Inc. (“Prudential”) filed a petition in interpleaderseeking to interplead 321,211 shares of Prudential common stock and anyassociated dividends arising from the demutualization of Prudential in December 2000.The shares of Prudential common stock related to group annuity contractspurchased by First-City National Bank of Houston, as trustee of the First CityBancorporation Employee Retirement Trust (the “Trust”) to fund obligations toparticipants in the First City Bancorporation Employee Retirement Plan (the “Plan”)in connection with termination of the Plan and the Trust in 1987. FirstCity,FCLT Loans Asset Corp. (“FCLT”), an alleged assignee of the FirstCityLiquidating Trust, JP Morgan Chase Bank, National Association (“JP Morgan”),and First-City National Bank of Houston as trustee of the Trust were madedefendants in the suit as claimants to the Prudential common stock anddividends. An agreed order dated January 27, 2005, was entered by theCourt providing that the Prudential common stock be transferred to JP Morgan asrecord owner and that JP Morgan sell the stock. The January 27, 2005 orderalso provided that the proceeds from the sale be held by JP Morgan pendingresolution, by agreement or court order, of all conflicting claims to theproceeds. JP Morgan advised that the Prudential common stock was sold on January 28,2005 for total proceeds of approximately $17.5 million. JP Morgan also receivedfunds in the amount of approximately $489,000, which were dividend paymentsrelated to the Prudential common stock. JP Morgan filed a third party actionnaming Mr. Blair as a third party defendant with an alleged interest inthe demutualization proceeds. On October 1, 2005, the court certified aclass represented by Mr. Blair.

On March 21,2006, FirstCity received notice that the 152nd District Court, Harris County, Texas grantedFirstCity’s motion for partial summary judgment. The Court’s summary judgmentorder additionally denied the claims to ownership of the demutualizationproceeds by FCLT and Mr. Blair, individually and as representative of theproposed class of employee beneficiaries. The proceeds are being held by JPMorgan pending resolution of the conflicting claims. According to JP Morgan’sreport dated as of the close of business June 30, 2006, thedemutualization proceeds held by JP Morgan totaled approximately $18 million.The order granting FirstCity’s motion for partial summary judgment renderedjudgment in favor of FirstCity as to the ownership of the demutualizationproceeds. The summary judgment order is not final, as all claims made by theparties were not addressed by the summary judgment motions filed by the partiesto the suit. FirstCity believes that the issues which were not resolved in theCourt’s order primarily relate to claims made by FCLT for alleged breach ofcontract by FirstCity in claiming the demutualization proceeds and allegedtortious interference by FirstCity with FCLT’s alleged right to thedemutualization proceeds. Mr. Blair, as class representative, has filed amotion for new trial to set aside the summary judgment in favor of FirstCityand for reconsideration of granting Mr. Blair’s motion for summaryjudgment. Mr. Blair’s motion was submitted to the Court on April 24,2006. The Court has not yet entered an order on Mr. Blair’s motion. FCLThas filed a motion for the Court to reconsider its order granting the partialsummary judgment for FirstCity. FCLT’s motion was submitted to the Court on May 1,2006. The Court has not yet entered an order on FCLT’s motion. FirstCity movedfor summary judgment on all remaining claims and for entry of a final judgmenton May 12, 2006. A hearing was held on that motion on June 23, 2006. TheCourt has not yet entered an order on FirstCity’s motion for summary judgment onthe remaining claims and has not entered a final judgment. FCLT and Mr. Blairhave already indicated their intent to appeal a final judgment awarding thedemutualization proceeds to FirstCity. The time period for filing of appealswill not begin until a final judgment is entered. FirstCity cannot give anyassurances as to the time period for the appeal of any final judgment or thetiming of receipt or ultimate amount of proceeds to be received, if any.

**Item 1A. Risk Factors.**

There have been nomaterial changes to the risk factors as previously disclosed under Item 1A inthe Company’s Annual Report on Form 10-K for the year ended December 31,2005.

**Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.**

None

34

----

** **

Table of Contents

**Item 3. DefaultsUpon Senior Securities.**

None

**Item 4. Submission of Mattersto a Vote of Security Holders.**

None

**Item 5. Other Information.**

None

**Item 6. Exhibits.**

*** ***
| Exhibit  Number | ** ** | ** ** | ** ** | **Description of Exhibit**                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
|-----------------|------------|------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1             |       | —     |       | Joint Plan of Reorganization by First City  Bancorporation of Texas, Inc., Official Committee of Equity Security  Holders and J-Hawk Corporation, with the Participation of Cargill Financial  Services Corporation, Under Chapter 11 of the United States Bankruptcy Code,  Case No. 392-39474-HCA-11 (incorporated herein by  reference to Exhibit 2.1 of the Company’s Current Report on Form 8-K  dated July 3, 1995 filed with the Commission on July 18, 1995). |
|            |       |       |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 2.2             |       | —     |       | Agreement and Plan of Merger, dated as of  July 3, 1995, by and between First City Bancorporation of  Texas, Inc. and J-Hawk Corporation (incorporated herein by reference to  Exhibit 2.2 of the Company’s Current Report on Form 8-K dated  July 3, 1995 filed with the Commission on July 18, 1995).                                                                                                                                                               |
|            |       |       |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 3.1             |       | —     |       | Amended and Restated Certificate of Incorporation of  the Company (incorporated herein by reference to Exhibit 3.1 of the  Company’s Current Report on Form 8-K dated July 3, 1995 filed  with the Commission on July 18, 1995).                                                                                                                                                                                                                                                |
|            |       |       |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 3.2             |       | —     |       | Bylaws of the Company (incorporated herein by  reference to Exhibit 3.2 of the Company’s Current Report on Form 8-K  dated July 3, 1995 filed with the Commission on July 18, 1995).                                                                                                                                                                                                                                                                                            |
|            |       |       |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.1            |       | —     |       | Revolving Credit Agreement, dated August 26,  2005, among FH Partners, L.P., as Borrower, and the Lenders named therein, as  Lenders, and Bank of Scotland, as Agent (incorporated herein by reference to  Exhibit 10.1 of the Company’s Form 8-K dated  September 1, 2005).                                                                                                                                                                                                    |
|            |       |       |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.2            |       | —     |       | Guaranty Agreement, dated August 26, 2005,  executed by FirstCity Financial Corporation, FirstCity Commercial  Corporation, FirstCity Europe Corporation, FirstCity Holdings Corporation,  FirstCity International Corporation, FirstCity Mexico, Inc., and FirstCity  Servicing Corporation for the benefit of Bank of Scotland, as agent, and  lenders (incorporated herein by reference to Exhibit 10.2 of the  Company’s Form 8-K dated September 1, 2005).            |
|            |       |       |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.3            |       | —     |       | Contribution and Assumption Agreement, dated  August 18, 2000, by and between Funding LP and Drive (incorporated  herein by reference to Exhibit 10.42 of the Company’s Form 8-K  dated August 25, 2000, filed with the Commission on September 11,  2000).                                                                                                                                                                                                                |
|            |       |       |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.4            |       | —     |       | Separation Agreement and Release, dated March 31,  2004, by and between G. Stephen Fillip, FirstCity Servicing Corporation and  FirstCity Financial Corporation (incorporated herein by reference to  Exhibit 10.19 of the Company’s Form 10-Q dated May 14,  2004).                                                                                                                                                                                                            |
|            |       |       |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.5            |       | —     |       | Consultant Agreement, dated April 1, 2004, by  and between FirstCity Servicing Corporation and G. Stephen Fillip  (incorporated herein by reference to Exhibit 10.20 of the Company’s  Form 10-Q dated May 14, 2004).                                                                                                                                                                                                                                                           |

 

35

----

 

** **

Table of Contents

 
| 10.6   |   | — |   | Securities Purchase Agreement dated as of  September 21, 2004 by and among FirstCity Financial Corporation and  certain affiliates of FirstCity and IFA Drive GP Holdings LLC, IFA Drive LP  Holdings LLC, Drive Management LP and certain affiliates of those persons.  (incorporated herein by reference to Exhibit 10.1 of the Company’s  Form 8-K dated September 27, 2004) |
|--------|--------|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.7   |   | — |   | Revolving Credit Agreement, dated November 12,  2004, among FirstCity Financial Corporation as Borrower and the Lenders named  therein, as Lenders, and Bank of Scotland, as Agent (incorporated herein by  reference to Exhibit 10.12 of the Company’s Form 10-Q dated  November 15, 2004)                                                                                     |
|   |   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.8   |   | — |   | 1995 Stock Option and Award Plan (incorporated  herein by reference to Exhibit A of the Company’s Schedule 14A,  Definitive Proxy Statement, dated March 27, 1996)                                                                                                                                                                                                                        |
|   |   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.9   |   | — |   | 1996 Stock Option and Award Plan (incorporated  herein by reference to Exhibit C of the Company’s Schedule 14A,  Definitive Proxy Statement, dated March 27, 1996)                                                                                                                                                                                                                        |
|   |   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.10  |   | — |   | 2004 Stock Option and Award Plan (incorporated  herein by reference to Appendix A of the Company’s Schedule 14A, Definitive  Proxy Statement, dated October 21, 2003)                                                                                                                                                                                                                          |
|   |   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.11  |   | — |   | Sixth Amendment to Right Of First Refusal Agreement  And Due Diligence Reimbursement Agreement dated effective as of  February 1, 2006 (incorporated herein by reference to Exhibit 10.1  of the Company’s Form 8-K dated February 6, 2006)                                                                                                                                     |
|   |   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.12  |   | — |   | Asset Purchase Agreement, dated June 30, 2006,  by and among FirstCity Financial Corporation and its subsidiaries, FirstCity  Business Lending Corporation and American Business Lending, Inc.; and  AMRESCO SBA Holdings, Inc. and NCS I, LLC (incorporated herein by reference  to Exhibit 10.1 of the Company’s Form 8-K dated July 7,  2006)                      |
|   |   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                     |
| 31.1*  |   | — |   | Certification of James T. Sartain, Chief Executive  Officer of the Company, pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                                                                                                                                                                                                                             |
|   |   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                     |
| 31.2*  |   | — |   | Certification of J. Bryan Baker, Chief Financial  Officer of the Company, pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                                                                                                                                                                                                                               |
|   |   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                     |
| 32.1*  |   | — |   | Certification of James T. Sartain, Chief Executive  Officer of the Company, pursuant to 18 U.S.C Section 1350 as adopted pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002 and relating to the  Quarterly Report on Form 10-Q for the quarter ended June 30,  2006.                                                                                                         |
|   |   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                     |
| 32.2*  |   | — |   | Certification of J. Bryan Baker, Chief Financial  Officer of the Company, pursuant to 18 U.S.C Section 1350 as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and relating  to the Quarterly Report on Form 10-Q for the quarter ended  June 30, 2006.                                                                                                           |

 

----

*           Filed herewith.

36

----

** **

Table of Contents

**SIGNATURES**

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

 
|                            | FIRSTCITY FINANCIAL  CORPORATION |
|----------------------------|----------------------------------|
|                       |                             |   |
|                       |                             |   |
|                       |                             |   |
|                       | By:                              | /s/  James T. Sartain |
|                       |                             | James T. Sartain |
| * *                   |                             | *President and Chief Executive* |
| * *                   |                             | *Officer and Director* |
| * *                   |                             | *(Duly authorized officer and* |
| * *                   |                             | *principal executive officer of the* |
| * *                   |                             | *Registrant)* |
| * *                   |                             | * * |
| * *                   |                             | * * |
| * *                   |                             | * * |
|                       | By:                              | /s/  J. Bryan Baker |
|                       |                             | J. Bryan Baker |
| * *                   |                             | *Senior Vice President and Chief* |
| * *                   |                             | *Financial Officer* |
| * *                   |                             | *(Duly authorized officer and* |
| * *                   |                             | *principal financial and accounting* |
| * *                   |                             | *officer of the Registrant)* |
| * *                   |                             | * * |
| Dated: August 9, 2006 |                             |   |

 

37

----

** **

Table of Contents

**Exhibit Index**

 
| Exhibit  Number | ** ** | ** ** | ** ** | **Description of Exhibit**                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
|-----------------|------------|------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1             |       | —     |       | Joint Plan of Reorganization by First City  Bancorporation of Texas, Inc., Official Committee of Equity Security  Holders and J-Hawk Corporation, with the Participation of Cargill Financial  Services Corporation, Under Chapter 11 of the United States Bankruptcy Code,  Case No. 392-39474-HCA-11 (incorporated herein by reference  to Exhibit 2.1 of the Company’s Current Report on Form 8-K  dated July 3, 1995 filed with the Commission on July 18, 1995). |
|            |       |       |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 2.2             |       | —     |       | Agreement and Plan of Merger, dated as of  July 3, 1995, by and between First City Bancorporation of Texas, Inc.  and J-Hawk Corporation (incorporated herein by reference to Exhibit 2.2  of the Company’s Current Report on Form 8-K dated July 3,  1995 filed with the Commission on July 18, 1995).                                                                                                                                                               |
|            |       |       |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 3.1             |       | —     |       | Amended and Restated Certificate of Incorporation of  the Company (incorporated herein by reference to Exhibit 3.1 of the  Company’s Current Report on Form 8-K dated July 3, 1995 filed  with the Commission on July 18, 1995).                                                                                                                                                                                                                                                |
|            |       |       |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 3.2             |       | —     |       | Bylaws of the Company (incorporated herein by  reference to Exhibit 3.2 of the Company’s Current Report on Form 8-K  dated July 3, 1995 filed with the Commission on July 18, 1995).                                                                                                                                                                                                                                                                                            |
|            |       |       |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.1            |       | —     |       | Revolving Credit Agreement, dated August 26,  2005, among FH Partners, L.P., as Borrower, and the Lenders named therein, as  Lenders, and Bank of Scotland, as Agent (incorporated herein by reference to  Exhibit 10.1 of the Company’s Form 8-K dated  September 1, 2005).                                                                                                                                                                                                    |
|            |       |       |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.2            |       | —     |       | Guaranty Agreement, dated August 26, 2005,  executed by FirstCity Financial Corporation, FirstCity Commercial Corporation,  FirstCity Europe Corporation, FirstCity Holdings Corporation, FirstCity  International Corporation, FirstCity Mexico, Inc., and FirstCity  Servicing Corporation for the benefit of Bank of Scotland, as agent, and  lenders (incorporated herein by reference to Exhibit 10.2 of the  Company’s Form 8-K dated September 1, 2005).            |
|            |       |       |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.3            |       | —     |       | Contribution and Assumption Agreement, dated  August 18, 2000, by and between Funding LP and Drive (incorporated  herein by reference to Exhibit 10.42 of the Company’s Form 8-K  dated August 25, 2000, filed with the Commission on September 11,  2000).                                                                                                                                                                                                                |
|            |       |       |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.4            |       | —     |       | Separation Agreement and Release, dated  March 31, 2004, by and between G. Stephen Fillip, FirstCity Servicing  Corporation and FirstCity Financial Corporation (incorporated herein by  reference to Exhibit 10.19 of the Company’s Form 10-Q dated  May 14, 2004).                                                                                                                                                                                                            |
|            |       |       |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.5            |       | —     |       | Consultant Agreement, dated April 1, 2004, by  and between FirstCity Servicing Corporation and G. Stephen Fillip  (incorporated herein by reference to Exhibit 10.20 of the Company’s  Form 10-Q dated May 14, 2004).                                                                                                                                                                                                                                                           |
|            |       |       |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.6            |       | —     |       | Securities Purchase Agreement dated as of  September 21, 2004 by and among FirstCity Financial Corporation and  certain affiliates of FirstCity and IFA Drive GP Holdings LLC, IFA Drive LP  Holdings LLC, Drive Management LP and certain affiliates of those persons.  (incorporated herein by reference to Exhibit 10.1 of the Company’s  Form 8-K dated September 27, 2004)                                                                                                 |
|            |       |       |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.7            |       | —     |       | Revolving Credit Agreement, dated November 12,  2004, among FirstCity Financial Corporation as Borrower and the Lenders named  therein, as Lenders, and Bank of Scotland, as Agent (incorporated herein by  reference to Exhibit 10.12 of the Company’s Form 10-Q dated  November 15, 2004)                                                                                                                                                                                     |
|            |       |       |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.8            |       | —     |       | 1995 Stock Option and Award Plan (incorporated  herein by reference to Exhibit A of the                                                                                                                                                                                                                                                                                                                                                                                                             |

 

----

** **

Table of Contents

 
|        |   |   |   | Company’s Schedule 14A, Definitive Proxy Statement,  dated March 27, 1996)                                                                                                                                                                                                                                                                                                |
|--------|--------|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |   |   |                                                                                                                                                                                                                                                                                                                                                                                |
| 10.9   |   | — |   | 1996 Stock Option and Award Plan (incorporated  herein by reference to Exhibit C of the Company’s Schedule 14A,  Definitive Proxy Statement, dated March 27, 1996)                                                                                                                                                                                                   |
|   |   |   |   |                                                                                                                                                                                                                                                                                                                                                                                |
| 10.10  |   | — |   | 2004 Stock Option and Award Plan (incorporated  herein by reference to Appendix A of the Company’s Schedule 14A, Definitive  Proxy Statement, dated October 21, 2003)                                                                                                                                                                                                     |
|   |   |   |   |                                                                                                                                                                                                                                                                                                                                                                                |
| 10.11  |   | — |   | Sixth Amendment to Right Of First Refusal Agreement  And Due Diligence Reimbursement Agreement dated effective as of  February 1, 2006 (incorporated herein by reference to Exhibit 10.1  of the Company’s Form 8-K dated February 6, 2006)                                                                                                                |
|   |   |   |   |                                                                                                                                                                                                                                                                                                                                                                                |
| 10.12  |   | — |   | Asset Purchase Agreement, dated June 30, 2006,  by and among FirstCity Financial Corporation and its subsidiaries, FirstCity  Business Lending Corporation and American Business Lending, Inc.; and  AMRESCO SBA Holdings, Inc. and NCS I, LLC (incorporated herein by  reference to Exhibit 10.1 of the Company’s Form 8-K dated  July 7, 2006) |
|   |   |   |   |                                                                                                                                                                                                                                                                                                                                                                                |
| 31.1*  |   | — |   | Certification of James T. Sartain, Chief Executive  Officer of the Company, pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                                                                                                                                                                                                        |
|   |   |   |   |                                                                                                                                                                                                                                                                                                                                                                                |
| 31.2*  |   | — |   | Certification of J. Bryan Baker, Chief Financial  Officer of the Company, pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                                                                                                                                                                                                          |
|   |   |   |   |                                                                                                                                                                                                                                                                                                                                                                                |
| 32.1*  |   | — |   | Certification of James T. Sartain, Chief Executive  Officer of the Company, pursuant to 18 U.S.C Section 1350 as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and relating  to the Quarterly Report on Form 10-Q for the quarter ended  June 30, 2006.                                                                                    |
|   |   |   |   |                                                                                                                                                                                                                                                                                                                                                                                |
| 32.2*  |   | — |   | Certification of J. Bryan Baker, Chief Financial  Officer of the Company, pursuant to 18 U.S.C Section 1350 as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and relating  to the Quarterly Report on Form 10-Q for the quarter ended  June 30, 2006.                                                                                      |

 

----