**UNITED STATES**

**SECURITIES 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 September 30, 2006** |
| ** **                                             |   | ** **                                                                                    |
| **o**                                                  |   | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**Commission file number 033-19694**

**FirstCity Financial Corporation**

(Exactname of registrant as 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’stelephone number, including area code)

Indicate by check mark whetherthe registrant: (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements for the past 90 days.  Yes x     No o

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

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

 

Indicate by check mark whetherthe registrant is a shell company (as defined in Rule 12b-2 of the ExchangeAct).  

Yes o      No x

The number of shares of common stock, par value $.01 pershare, outstanding at November 9, 2006 was 11,316,937.

 

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**TABLEOF 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                                                       |

 

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Table of Contents

**PART I**

**FINANCIAL INFORMATION**

**Item 1.  Financial Statements.**

**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES**

** **

**CONSOLIDATED BALANCE SHEETS**

**(Dollars inthousands, except per share data)**
| ** **                                                                                                                                       | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                       | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| ** **                                                                                                                                       | ** ** | **(Unaudited)**        | ** ** | ** **            | ** ** |
| **ASSETS**                                                                                                                                       | ** ** | ** **             | ** ** | ** **            | ** ** |
| Cash and cash  equivalents                                                                                                                       |       | $                      | 13,036     |                  | $          | 12,901 |   |
| Portfolio Assets, net                                                                                                                            |       | 78,908                 |       | 49,346                |       |
| Loans receivable from  Acquisition Partnerships held for investment                                                                              |       | 7,144                  |       | 19,606                |       |
| Loans receivable -  other                                                                                                                        |       | 2,292                  |       | —                |       |
| Equity investments                                                                                                                               |       | 84,853                 |       | 83,785                |       |
| Deferred tax asset, net                                                                                                                          |       | 20,101                 |       | 20,101                |       |
| Service fees receivable  from affiliates                                                                                                         |       | 1,096                  |       | 1,103                 |       |
| Other assets, net                                                                                                                                |       | 5,925                  |       | 7,870                 |       |
| Discontinued mortgage  assets                                                                                                                    |       | 103                    |       | 157                   |       |
| Total Assets                                                                                                                                     |       | $                      | 213,458    |                  | $          | 194,869 |   |
|                                                                                                                                             | ** ** | ** **             | ** ** | ** **            | ** ** |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                   |       |                   |       |                  |       |
| Liabilities:                                                                                                                                     |       |                   |       |                  |       |
| Notes payable  other                                                                                                                             |       | $                      | 105,963    |                  | $          | 89,653 |   |
| Notes payable to  affiliates                                                                                                                     |       | —                 |       | 606                   |       |
| Minority  interest                                                                                                                               |       | 1,800                  |       | 1,193                 |       |
| Liabilities from  discontinued consumer operations                                                                                               |       | 72                     |       | 121                   |       |
| Other  liabilities                                                                                                                               |       | 3,974                  |       | 4,385                 |       |
| Total  Liabilities                                                                                                                               |       | 111,809                |       | 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:  11,316,937 and 11,307,187, respectively) |       | 113                    |       | 113                   |       |
| Treasury stock,  at cost: 530,300 shares and zero shares, respectively                                                                           |       | (5,571                 | )          | —                |       |
| Paid in capital                                                                                                                                  |       | 100,378                |       | 99,843                |       |
| Retained  earnings (accumulated deficit)                                                                                                         |       | 6,194                  |       | (2,058                | )          |
| Accumulated  other comprehensive income                                                                                                          |       | 535                    |       | 1,013                 |       |
| Total  Stockholders’ Equity                                                                                                                 |       | 101,649                |       | 98,911                |       |
| Total Liabilities and  Stockholders’ Equity                                                                                                 |       | $                      | 213,458    |                  | $          | 194,869 |   |

 

See accompanying notes to consolidated financial statements.

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Table of Contents

**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES**

 

**CONSOLIDATED STATEMENTS OFOPERATIONS**

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

**(Unaudited)**
| ** **                                                                     | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                     | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                                     | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenues:                                                                      | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** |   |   |   |
| Servicing fees from affiliates                                                 |       | $                                | 4,679      |                            | $          | 2,891 |   | $ | 10,182 |   | $ | 8,972 |   |
| Income from Portfolio Assets                                                   |       | 2,547                            |       | 2,124                           |       | 7,551 |   | 6,269 |   |
| Interest income from affiliates                                                |       | 294                              |       | 420                             |       | 1,189 |   | 1,293 |   |
| Interest income from loans receivable - other                                  |       | 17                               |       | —                          |       | 17 |   | — |   |
| Other income                                                                   |       | 654                              |       | 269                             |       | 1,846 |   | 1,079 |   |
| Total revenues                                                                 |       | 8,191                            |       | 5,704                           |       | 20,785 |   | 17,613 |   |
| Expenses:                                                                      |       |                             |       |                            |       |   |   |   |   |
| Interest and fees on notes payable — other                                |       | 1,797                            |       | 909                             |       | 5,433 |   | 2,619 |   |
| Interest and fees on notes payable to affiliates                               |       | 2                                |       | 9                               |       | 22 |   | 27 |   |
| Salaries and benefits                                                          |       | 4,094                            |       | 3,571                           |       | 11,110 |   | 11,413 |   |
| Provision for loan and impairment losses                                       |       | 50                               |       | 322                             |       | 101 |   | 436 |   |
| Occupancy, data processing, communication and other                            |       | 2,688                            |       | 1,908                           |       | 6,165 |   | 5,574 |   |
| Total expenses                                                                 |       | 8,631                            |       | 6,719                           |       | 22,831 |   | 20,069 |   |
| Equity in  earnings of investments                                             |       | 3,023                            |       | 1,783                           |       | 8,044 |   | 8,874 |   |
| Gain on sale of  interest in equity investments                                |       | 2,378                            |       | —                          |       | 2,405 |   | — |   |
| Earnings from  continuing operations before income taxes and minority interest |       | 4,961                            |       | 768                             |       | 8,403 |   | 6,418 |   |
| Income tax benefit (expense)                                                   |       | 4                                |       | (79                             | )          | (140 | ) | (321 | ) |
| Minority interest                                                              |       | 2                                |       | 3                               |       | 64 |   | (36 | ) |
| Earnings from  continuing operations                                           |       | 4,967                            |       | 692                             |       | 8,327 |   | 6,061 |   |
| Discontinued  operations                                                       |       |                             |       |                            |       |   |   |   |   |
| Loss from discontinued operations                                              |       | —                           |       | (281                            | )          | (75 | ) | (378 | ) |
| Income taxes                                                                   |       | —                           |       | 600                             |       | — |   | 600 |   |
| Net earnings (loss) from discontinued operations                               |       | —                           |       | 319                             |       | (75 | ) | 222 |   |
| Net earnings                                                                   |       | $                                | 4,967      |                            | $          | 1,011 |   | $ | 8,252 |   | $ | 6,283 |   |
| Basic earnings  per common share are as follows:                               |       |                             |       |                            |       |   |   |   |   |
| Earnings from continuing operations                                            |       | $                                | 0.45       |                            | $          | 0.06 |   | $ | 0.74 |   | $ | 0.54 |   |
| Discontinued operations                                                        |       | $                                | —     |                            | $          | 0.03 |   | $ | (0.01 | ) | $ | 0.02 |   |
| Net earnings to common stockholders                                            |       | $                                | 0.45       |                            | $          | 0.09 |   | $ | 0.73 |   | $ | 0.56 |   |
| Weighted average common shares outstanding                                     |       | 11,104                           |       | 11,298                          |       | 11,239 |   | 11,278 |   |
| Diluted earnings  per common share are as follows:                             |       |                             |       |                            |       |   |   |   |   |
| Earnings from continuing operations                                            |       | $                                | 0.42       |                            | $          | 0.05 |   | $ | 0.70 |   | $ | 0.50 |   |
| Discontinued operations                                                        |       | $                                | —     |                            | $          | 0.03 |   | $ | (0.01 | ) | $ | 0.02 |   |
| Net earnings to common stockholders                                            |       | $                                | 0.42       |                            | $          | 0.08 |   | $ | 0.69 |   | $ | 0.52 |   |
| Weighted average  common shares outstanding                                    |       | 11,711                           |       | 12,008                          |       | 11,875 |   | 12,012 |   |

 

See accompanying notes to consolidated financial statements.

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**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES**

** **

**CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY**

**AND COMPREHENSIVE INCOME**

**(Dollars in thousands)**

 
| ** **                                                                 | ** ** | ** **            | ** ** | ** **              | ** ** | ** **       | ** ** | ** **       | ** ** | ** **        | ** ** | **Retained**           | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
|----------------------------------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|------------------|------------|------------------|------------|-------------------|------------|------------------------|------------|-----------------|------------|------------|------------|
| ** **                                                                 | ** ** | ** **            | ** ** | ** **              | ** ** | ** **       | ** ** | ** **       | ** ** | ** **        | ** ** | **Earnings**           | ** ** | **Other**       | ** ** | **Total**  | ** ** |
| ** **                                                                 | ** ** | **Common Stock** | ** ** | **Treasury Stock** | ** ** | **Paid in** | ** ** | **(Accumulated** | ** ** | **Comprehensive** | ** ** | **Stockholders’** | ** ** |
| ** **                                                                 | ** ** | **Shares**            | ** ** | **Amount**              | ** ** | **Shares**       | ** ** | **Amount**       | ** ** | **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                                          |       | 9,750                 |       | —                  |       | —           |       | —           |       | 68                |       | —                 |       | —          |       | 68         |       |
| Repurchase of  common stock                                                |       | —                |       | —                  |       | 530,300          |       | (5,571           | )          | —            |       | —                 |       | —          |       | (5,571     | )          |
| Additional  paid-in capital arising from stock option compensation expense |       | —                |       | —                  |       | —           |       | —           |       | 467               |       | —                 |       | —          |       | 467        |       |
| Comprehensive  income:                                                     |       |                  |       |                    |       |             |       |             |       |              |       |                   |       |            |       |       |       |
|  Net earnings for the first nine months of  2006                      |       | —                |       | —                  |       | —           |       | —           |       | —            |       | 8,252                  |       | —          |       | 8,252      |       |
|  Translation adjustments                                              |       | —                |       | —                  |       | —           |       | —           |       | —            |       | —                 |       | (478            | )          | (478       | )          |
| Total  comprehensive income                                                |       |                  |       |                    |       |             |       |             |       |              |       |                   |       |            |       | 7,774      |       |
| **Balances, September 30, 2006  (unaudited)**                              |       | 11,316,937            |       | $                       | 113        |             | 530,300    |             | $          | (5,571            | )          | $                      | 100,378    |            | $          | 6,194      |       | $ | 535 |   | $ | 101,649 |   |

 

See accompanying notes to consolidated financial statements.

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Table of Contents

**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES**

** **

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Dollars in thousands)**

**(Unaudited)**
| ** **                                                                       | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                       | ** ** | **September 30,**          | ** ** |
| ** **                                                                       | ** ** | **2006**                        | ** ** | **2005** | ** ** |
| Cash flows from  operating activities:                                           |       |                            |       |   |   |
| Net earnings                                                                     |       | $                               | 8,252      |   | $ | 6,283 |   |
| Adjustments to reconcile net earnings to net cash  used in operating activities: |       |                            |       |   |   |
| Net (earnings) loss from discontinued operations                                 |       | 75                              |       | (222 | ) |
| Purchase and advances of Portfolio Assets and loans  receivable, net             |       | (64,759                         | )          | (19,306 | ) |
| Proceeds applied to principal on Portfolio Assets  and loans receivable          |       | 32,432                          |       | 22,092 |   |
| Income from Portfolio Assets                                                     |       | (7,551                          | )          | (6,269 | ) |
| Capitalized interest and costs on Portfolio Assets  and loans receivable         |       | (452                            | )          | (217 | ) |
| Provision for loan and impairment losses                                         |       | 101                             |       | 436 |   |
| Equity in earnings of investments                                                |       | (8,044                          | )          | (8,874 | ) |
| Gain on sale of interest in equity investments                                   |       | (2,405                          | )          | — |   |
| Depreciation and amortization                                                    |       | 391                             |       | 661 |   |
| Stock-based compensation expense related to stock  options                       |       | 467                             |       | — |   |
| Decrease in service fees receivable from affiliates                              |       | 7                               |       | 362 |   |
| Decrease (increase) in other assets                                              |       | 791                             |       | (489 | ) |
| Change in debt imputed value                                                     |       | (293                            | )          | 214 |   |
| Decrease in other liabilities                                                    |       | (539                            | )          | (1,722 | ) |
| Net cash used in operating activities                                            |       | (41,527                         | )          | (7,051 | ) |
| Cash flows from  investing activities:                                           |       |                            |       |   |   |
| Property and equipment, net                                                      |       | (135                            | )          | (108 | ) |
| Proceeds from sale of interest in equity investments                             |       | 8,689                           |       | — |   |
| Contributions to Acquisition Partnerships and  Servicing Entities                |       | (39,406                         | )          | (18,373 | ) |
| Distributions from Acquisition Partnerships and  Servicing Entities              |       | 63,346                          |       | 17,907 |   |
| Net cash provided by (used in) investing activities                              |       | 32,494                          |       | (574 | ) |
| Cash flows from  financing activities:                                           |       |                            |       |   |   |
| Borrowings under notes payable — other                                      |       | 106,569                         |       | 68,622 |   |
| Payments of notes payable to affiliates                                          |       | (312                            | )          | (34 | ) |
| Payments of notes payable — other                                           |       | (91,566                         | )          | (56,427 | ) |
| Repurchase of common stock                                                       |       | (5,571                          | )          | — |   |
| Proceeds from issuance of common stock                                           |       | 68                              |       | 162 |   |
| Net cash provided by financing activities                                        |       | 9,188                           |       | 12,323 |   |
| Net cash provided by continuing operations                                       |       | 155                             |       | 4,698 |   |
| Cash flows from  discontinued operations (Revised - see note 1):                 |       |                            |       |   |   |
| Net cash used in operating activities                                            |       | (20                             | )          | (8,229 | ) |
| Net cash provided by investing activities                                        |       | —                          |       | 1,329 |   |
| Net cash used in discontinued operations                                         |       | (20                             | )          | (6,900 | ) |
| Net increase (decrease)  in cash and cash equivalents                            |       | 135                             |       | (2,202 | ) |
| Cash and cash  equivalents, beginning of period                                  |       | 12,901                          |       | 9,724 |   |
| Cash and cash  equivalents, end of period                                        |       | $                               | 13,036     |   | $ | 7,522 |   |
| Supplemental  disclosure of cash flow information:                               |       |                            |       |   |   |
| Cash paid during the period for:                                                 |       |                            | ** ** | ** ** | ** ** |
| Interest                                                                         |       | $                               | 4,636      |   | $ | 1,982 |   |
| Income taxes,  net of refunds received                                           |       | 121                             |       | 317 |   |

 

See accompanying notes to consolidated financial statements.

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**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTSSeptember 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 September 30, 2006, the Company wasengaged in 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 September 30,2006, its results of operations for the three and nine month periods endedSeptember 30, 2006 and 2005 and cash flows for the nine month periods endedSeptember 30, 2006 and 2005.  Certaindisclosures have been condensed or omitted from these financial statements.Accordingly, these financial statements should be read with the consolidatedfinancial statements included in the Company’s 2005 Annual Report on Form10-K.  Certain amounts in the consolidatedfinancial statements for prior years have been reclassified to conform withcurrent consolidated financial statement presentation.  In the first quarter of 2006, equityin earnings of investments was reclassified outside of revenues, which in priorperiods was included with revenues.  Alsoin the first quarter of 2006, the Company has separately disclosed theoperating, investing and financing portions of the cash flows attributable toits discontinued operations, which in prior periods were reported on a combinedbasis as a single amount.  In the secondquarter of 2006, the Company reclassified gain on resolution of PortfolioAssets and loan interest 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.

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**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in Thousands,except per share data)—(continued)**

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 nine months ended September 30, 2006,reflect the impact of adopting SFAS 123(R). In accordance with the modifiedprospective method, the consolidated financial statements for prior periodshave not been restated to reflect, and do not include, the impact of SFAS123(R). See Note 9 for further details.

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 nine months ended September 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 nine months ended September 30, 2006,is based on awards ultimately expected to vest, it has been reduced forestimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at thetime of grant and revised, if necessary, in subsequent periods if actualforfeitures differ from those estimates. In the pro forma information requiredunder SFAS 148 for the periods prior to 2006, we accounted for forfeitures asthey occurred.

**(2)  New Accounting Pronouncements**

In September 2006, Statement of Financial AccountingStandards (SFAS) No. 157, *Fair Value Measurements*,was issued. SFAS No. 157 provides guidance for using fair value to measureassets and liabilities. It applies whenever other standards require (or permit)assets or liabilities to be measured at fair value but does not expand the useof fair value in any new circumstances. The provisions of Statement 157 areeffective for financial statements issued for fiscal years beginning afterNovember 15, 2007. The effect of adopting SFAS No. 157 has not been determined,but it is not expected to have a significant effect on the Company’sconsolidated financial position or earnings.

In September 2006, the SEC staff issued StaffAccounting Bulletin Topic 1N, Financial Statements - Considering the Effects ofPrior Year Misstatements when Quantifying Misstatements in Current YearFinancial Statements (“SAB 108”). SAB 108 provides guidance on how prior yearmisstatements should be evaluated when determining the materiality ofmisstatements in the current year financial statements. SAB 108 requiresmateriality to be determined by considering the effect of prior yearmisstatements on both the current year balance sheet and income statement, withconsideration of their carryover and reversing effects. SAB 108 also addresseshow to correct material misstatements. The provisions of SAB 108 are effectivefor financial statements issued for fiscal years ending after November 15,2006. The effect of adopting SAB 108 has not been determined, but it is notexpected to have a significant effect on our reported financial position orearnings.

In July 2006, the Financial Accounting Standards Board(“FASB”) issued FASB Interpretation No. (“FIN”) 48, Accounting for Uncertaintyin Income Taxes (“FIN No. 48”). FIN No. 48 clarifies the accounting foruncertainty in income taxes recognized in an enterprise’s financial statementsin accordance with FASB Statement of Financial Accounting Standards (“SFAS”)No. 109, Accounting for Income Taxes . FIN No. 48 prescribes a recognitionthreshold and measurement attribute for the financial statement recognition andmeasurement of a tax position taken or expected to be taken in a tax return.FIN No. 48 is effective for fiscal years beginning after December 15, 2006. TheCompany is evaluating any future effect of this pronouncement.

In March 2006, the FASB issued SFAS No. 156,Accounting for Servicing of Financial Assets—an amendment of FASB Statement No.140 (“SFAS 156”). SFAS 156 requires an entity to recognize a servicing asset orliability each time it undertakes an obligation to service a financial asset byentering into a servicing contract in specified situations. Such servicingassets or liabilities would be initially measured at fair value, ifpracticable, and subsequently measured at amortized value or fair value basedupon an election of the reporting entity. SFAS 156 also specifies certainfinancial statement presentations and disclosures in connection with servicingassets and liabilities. SFAS 156 is effective for fiscal years beginning afterSeptember 15, 2006 and may be adopted earlier but only if the adoption is inthe first quarter of the fiscal year. FirstCity did not adopt in 2006 and doesnot expect that the adoption of SFAS 156 in future periods will have a materialeffect on its Consolidated Financial Statements.

In November 2005, the FASB issued FASB Staff PositionSFAS 115-1, The Meaning of Other-Than-Temporary Impairment and Its Applicationto Certain Investments (“FSP 115-1”). FSP 115-1 addresses the determination as to when an investment isconsidered impaired, whether that impairment is other than temporary, and themeasurement of an impaired loss.  FSP115-1 also includes accounting considerations subsequent to the recognition ofan other-than-temporary impairment and requires certain disclosures about

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**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in Thousands,except per share data)—(continued)**

unrealized losses that have not been recognized asother-than-temporary impairments.  TheCompany adopted the provisions of FSP 115-1 on January 1, 2006, and did nothave a significant impact on the Company’s consolidated 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”).  Earnings (losses)from discontinued operations, net of taxes, are summarized as follows:

|                                                   | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                        | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                        | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Mortgage                                          |       | $                                | —     |                            | $          | (252 | ) | $ | (75 | ) | $ | (346 | ) |
| Consumer                                          |       | —                           |       | 571                             |       | — |   | 568 |   |
| Net earnings  (loss) from discontinued operations |       | $                                | —     |                            | $          | 319 |   | $ | (75 | ) | $ | 222 |   |

 

*Mortgage*

At September 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 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 recorded provisionsof $54 and $321 in the first nine months of 2006 and 2005, respectively, forlosses 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.  AtSeptember 30, 2006, the acquired loans are included in Portfolio Assets in theconsolidated balance sheet and classified as either “loans acquired with creditdeterioration” or “loans acquired with no credit deterioration.”

*Consumer*

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

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**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in Thousands,except per share data)—(continued)**

**(4)  Portfolio Assets**

Portfolio Assets are summarized as follows: 

|                                             | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                  | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| Loan Portfolios                             | ** ** | ** **             | ** ** | ** **            | ** ** |
| Loans Acquired Prior to 2005                | ** ** | ** **             | ** ** | ** **            | ** ** |
| Non-performing Portfolio Assets             |       | $                      | 7,123      |                  | $          | 10,528 |   |
| Performing Portfolio Assets                 |       | 5,612                  |       | 12,029                |       |
| Loans Acquired After 2004                   | ** ** | ** **             | ** ** | ** **            | ** ** |
| Loans acquired with credit deterioration    |       | 56,282                 |       | 12,703                |       |
| Loans acquired with no credit deterioration |       | 3,076                  |       | 3,976                 |       |
| Outstanding balance                         |       | 72,093                 |       | 39,236                |       |
| Allowance for loan losses                   |       | (192                   | )          | (163                  | )          |
| Carrying amount of loans, net of allowance  |       | 71,901                 |       | 39,073                |       |
|                                        |       |                   |       |                  |       |
| Real Estate  Portfolios                     |       | 4,875                  |       | 8,018                 |       |
| Other                                       |       | 2,132                  |       | 2,255                 |       |
| Portfolio  Assets, net                      |       | $                      | 78,908     |                  | $          | 49,346 |   |

 

Income from Portfolio Assets is summarized as follows:

|                                             | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                  | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                  | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Loan Portfolios                             | ** ** | ** **                       | ** ** | ** **                      |       |   |   |   |   |
| Loans Acquired Prior to 2005                | ** ** | ** **                       | ** ** | ** **                      |       |   |   |   |   |
| Non-performing Portfolio Assets             |       | $                                | 540        |                            | $          | 1,080 |   | $ | 2,392 |   | $ | 3,663 |   |
| Performing Portfolio Assets                 |       | 412                              |       | 399                             |       | 1,293 |   | 1,746 |   |
| Loans Acquired After 2004                   | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Loans acquired with credit deterioration    |       | 1,403                            |       | 250                             |       | 2,412 |   | 361 |   |
| Loans acquired with no credit deterioration |       | 93                               |       | 176                             |       | 277 |   | 250 |   |
| Real Estate  Portfolios                     |       | 123                              |       | 169                             |       | 995 |   | 199 |   |
| Other                                       |       | (24                              | )          | 50                              |       | 182 |   | 50 |   |
| Income from  Portfolio Assets               |       | $                                | 2,547      |                            | $          | 2,124 |   | $ | 7,551 |   | $ | 6,269 |   |

 

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 filed with the Securities and ExchangeCommission on March 16, 2006 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 $101 for the nine monthperiod ended September 30, 2006, which is comprised of a $24 impairment chargeon real estate portfolios and a $77 allowance for loan losses, net ofrecoveries.  For the nine month periodended September 30, 2005, the Company recorded an allowance for impairment onPortfolio Assets of $436, which is comprised of a $17 impairment charge on realestate portfolios and a $419 allowance for loan losses.

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**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in Thousands,except per share data)—(continued)**

The changes in the allowance for loan losses are asfollows:

|                    | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **         | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **         | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Beginning  Balance |       | $                                | (197       | )                               | $          | (114 | ) | $ | (163 | ) | $ | — |   |
| Provisions         |       | (42                              | )          | (315                            | )          | (183 | ) | (429 | ) |
| Recoveries         |       | 14                               |       | 10                              |       | 106 |   | 10 |   |
| Charge Offs        |       | 33                               |       | —                          |       | 48 |   | — |   |
| Ending Balance     |       | $                                | (192       | )                               | $          | (419 | ) | $ | (192 | ) | $ | (419 | ) |

 

Changes in accretable yield for loans acquired withcredit deterioration are as follows:

|                                                     | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                          | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                          | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Beginning  Balance                                  |       | $                                | 9,660      |                            | $          | 2,830 |   | $ | 3,765 |   | $ | — |   |
| Additions                                           |       | 9,710                            |       | 326                             |       | 16,614 |   | 3,267 |   |
| Accretion                                           |       | (980                             | )          | (250                            | )          | (1,984 | ) | (361 | ) |
| Reclassification from (to) nonaccretable difference |       | (111                             | )          | —                          |       | (111 | ) | — |   |
| Disposals                                           |       | (423                             | )          | (206                            | )          | (428 | ) | (206 | ) |
|  Ending Balance                                |       | $                                | 17,856     |                            | $          | 2,700 |   | $ | 17,856 |   | $ | 2,700 |   |

 

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** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                          | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                          | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Face value at  acquisition                          |       | $                                | 132,926    |                            | $          | 1,354 |   | $ | 176,566 |   | $ | 15,851 |   |
| Cash flows  expected to be collected at acquisition |       | 39,608                           |       | 1,311                           |       | 69,572 |   | 15,004 |   |
| Basis in acquired loans  at acquisition             |       | 29,898                           |       | 985                             |       | 52,958 |   | 11,737 |   |
|                                                     |            |                                  |            |                                 |            |  |  |  |  |  |  |  |  |

 

**(5)  Loans Receivable**

Loans receivable from Acquisition Partnerships held for investment aresummarized as follows:

|               | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|---------------|------------|------------------------|------------|-----------------------|------------|
| ** **    | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| Latin America |       | $                      | 1,360      |                  | $          | 16,098 |   |
| Europe        |       | 3,411                  |       | 1,674                 |       |
| Domestic      |       | 2,373                  |       | 1,834                 |       |
|          |       | $                      | 7,144      |                  | $          | 19,606 |   |

 

In August 2006, FirstCitycompleted a restructuring of its investments in Mexico in a transaction withAmerican International Group, Inc. (“AIG”). As a result, FirstCity eliminated substantially all of its loansreceivable from Mexico acquisition partnerships (see Note 6).

There were no provisions recorded on these loansduring the first nine 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

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**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in Thousands,except per share data)—(continued)**

to repay these notes. The Company applies the assetvaluation methodology consistently in all venues and uses the same proprietaryasset management system to evaluate impairment on all asset pools. The resultsof this evaluation indicated that cash flows from the pools will be sufficientto repay the loans and no allowances for impairment are necessary.

Equity method losses which were recorded to reduce theloans and interest receivable from certain Mexican partnerships were      zero and $.5 million during the firstnine months of 2006 and 2005, respectively, in compliance with EITF 98-13, *Accounting by an Equity Method Investor for InvesteeLosses When the Investor Has Loans to and Investments in Other Securities ofthe Investee*, and EITF 99-10, *Percentage Used toDetermine the Amount of Equity Method Losses.*

In September 2006, FirstCity invested $2.3 million inthe form of a loan to a Canadian real estate development company.

**(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 CombinedBalance Sheets**

|                                                | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                     | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| Assets                                         |       | $                      | 391,925    |                  | $          | 444,825 |   |
| Liabilities                                    |       | $                      | 185,266    |                  | $          | 340,881 |   |
| Net equity                                     |       | 206,659                |       | 103,944               |       |
|                                           |       | $                      | 391,925    |                  | $          | 444,825 |   |
|                                           |       |                   |       |                  |       |
| Equity  investment in Acquisition Partnerships |       | $                      | 79,096     |                  | $          | 77,893 |   |
| Equity  investment in servicing entities       |       | 5,757                  |       | 5,892                 |       |
|                                           |       | $                      | 84,853     |                  | $          | 83,785 |   |

 

**Condensed CombinedSummary of Operations**

|                                                  | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                       | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                       | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Income from  Portfolio Assets                    |       | $                                | 26,066     |                            | $          | 16,935 |   | $ | 64,572 |   | $ | 59,477 |   |
| Other income                                     |       | 336                              |       | 252                             |       | 1,884 |   | 621 |   |
| Revenues                                         |       | 26,402                           |       | 17,187                          |       | 66,456 |   | 60,098 |   |
| Interest expense                                 |       | 4,931                            |       | 3,559                           |       | 11,239 |   | 11,736 |   |
| Service fees                                     |       | 5,486                            |       | 5,416                           |       | 12,681 |   | 14,803 |   |
| Other operating  costs                           |       | 7,914                            |       | 9,037                           |       | 17,154 |   | 21,752 |   |
| Foreign currency  (gains) losses                 |       | (4,660                           | )          | (113                            | )          | 8,558 |   | (9,188 | ) |
| Income taxes                                     |       | 234                              |       | 269                             |       | 596 |   | 1,070 |   |
| Expenses                                         |       | 13,905                           |       | 18,168                          |       | 50,228 |   | 40,173 |   |
| Net earnings (loss)                              |       | $                                | 12,497     |                            | $          | (981 | ) | $ | 16,228 |   | $ | 19,925 |   |
|                                             |       |                             |       |                            |       |   |   |   |   |
| Equity in  earnings of Acquisition Partnerships  |       | $                                | 2,992      |                            | $          | 1,975 |   | $ | 7,811 |   | $ | 8,385 |   |
| Equity in  earnings (loss) of servicing entities |       | 31                               |       | (192                            | )          | 233 |   | 489 |   |
|                                             |       | $                                | 3,023      |                            | $          | 1,783 |   | $ | 8,044 |   | $ | 8,874 |   |

 

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**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in Thousands,except per share data)—(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.

|                                                 | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| Assets:                                         |       |                   |       |                  |       |
| Domestic:                                       |       |                   |       |                  |       |
| WAMCO Partnerships                              |       | $                      | 138,676    |                  | $          | 166,213 |   |
| MinnTex Investment Partners LP                  |       | 148                    |       | 307                   |       |
| Other                                           |       | 10,718                 |       | 10,410                |       |
| Latin America                                   |       | 177,301                |       | 185,702               |       |
| Europe                                          |       | 65,082                 |       | 82,193                |       |
|                                            |       | $                      | 391,925    |                  | $          | 444,825 |   |
|                                            |       |                   |       |                  |       |
| Equity  (deficit):                              |       |                   |       |                  |       |
| Domestic:                                       |       |                   |       |                  |       |
| WAMCO Partnerships                              |       | $                      | 79,582     |                  | $          | 111,329 |   |
| MinnTex Investment Partners LP                  |       | 126                    |       | 283                   |       |
| Other                                           |       | 5,012                  |       | 5,485                 |       |
| Latin America                                   |       | 70,189                 |       | (79,527               | )          |
| Europe                                          |       | 51,750                 |       | 66,374                |       |
|                                            |       | $                      | 206,659    |                  | $          | 103,944 |   |
| Equity  investment in Acquisition Partnerships: |       |                   |       |                  |       |
| Domestic:                                       |       |                   |       |                  |       |
| WAMCO Partnerships                              |       | $                      | 39,052     |                  | $          | 51,772 |   |
| MinnTex Investment Partners LP                  |       | 42                     |       | 93                    |       |
| Other                                           |       | 2,379                  |       | 2,825                 |       |
| Latin America                                   |       | 19,251                 |       | 2,771                 |       |
| Europe                                          |       | 18,372                 |       | 20,432                |       |
|                                            |       | $                      | 79,096     |                  | $          | 77,893 |   |

 

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**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in Thousands, exceptper share data)—(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** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenues:                                 |       |                             |       |                            |       |   |   |   |   |
| Domestic:                                 |       |                             |       |                            |       |   |   |   |   |
| WAMCO Partnerships                        |       | $                                | 6,719      |                            | $          | 4,591 |   | $ | 21,218 |   | $ | 21,599 |   |
| MinnTex Investment Partners LP            |       | 353                              |       | 991                             |       | 1,242 |   | 4,098 |   |
| Other                                     |       | 27                               |       | 866                             |       | 323 |   | 932 |   |
| Latin America                             |       | 14,382                           |       | 6,053                           |       | 27,206 |   | 17,267 |   |
| Europe                                    |       | 4,921                            |       | 4,686                           |       | 16,467 |   | 16,202 |   |
| ** **                                |       | $                                | 26,402     |                            | $          | 17,187 |   | $ | 66,456 |   | $ | 60,098 |   |
|                                      |       |                             |       |                            |       |   |   |   |   |
| Net earnings  (loss):                     |       |                             |       |                            |       |   |   |   |   |
| Domestic:                                 |       |                             |       |                            |       |   |   |   |   |
| WAMCO Partnerships                        |       | $                                | 3,233      |                            | $          | 2,079 |   | $ | 10,538 |   | $ | 9,706 |   |
| MinnTex Investment Partners LP            |       | 321                              |       | 900                             |       | 1,118 |   | 3,676 |   |
| Other                                     |       | (460                             | )          | 614                             |       | (590 | ) | 381 |   |
| Latin America                             |       | 6,307                            |       | (7,522                          | )          | (6,001 | ) | (4,777 | ) |
| Europe                                    |       | 3,096                            |       | 2,948                           |       | 11,163 |   | 10,939 |   |
|                                      |       | $                                | 12,497     |                            | $          | (981 | ) | $ | 16,228 |   | $ | 19,925 |   |
| Equity in  earnings (loss) of Acquisition |       |                             |       |                            |       |   |   |   |   |
| Partnerships:                             |       |                             |       |                            |       |   |   |   |   |
| Domestic:                                 |       |                             |       |                            |       |   |   |   |   |
| WAMCO Partnerships                        |       | $                                | 1,394      |                            | $          | 1,162 |   | $ | 5,026 |   | $ | 4,518 |   |
| MinnTex Investment Partners LP            |       | 106                              |       | 297                             |       | 369 |   | 1,213 |   |
| Other                                     |       | (218                             | )          | 325                             |       | (259 | ) | 277 |   |
| Latin America                             |       | 815                              |       | (441                            | )          | (316 | ) | (250 | ) |
| Europe                                    |       | 895                              |       | 632                             |       | 2,991 |   | 2,627 |   |
|                                      |       | $                                | 2,992      |                            | $          | 1,975 |   | $ | 7,811 |   | $ | 8,385 |   |

 

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**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in Thousands,except per share data)—(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 EndedSeptember 30, 2006**
| ** **                                      | ** ** | **WAMCO** | ** ** | **WAMCO** | ** ** | **WAMCO** | ** ** | **Other**        | ** ** | ** **   | ** ** |
|-------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|------------------|------------|--------------|------------|
| ** **                                      | ** ** | **30**    | ** ** | **31**    | ** ** | **33**    | ** ** | **Partnerships** | ** ** | **Combined** | ** ** |
| Income from  Portfolio Assets                   |       | $         | 576        |      | $          | 294       |       | $                | 1,817      |         | $          | 3,855 |   | $ | 6,542 |   |
| Other income,  net                              |       | 3         |       | 18        |       | 37        |       | 119              |       | 177          |       |
| Revenues                                        |       | 579       |       | 312       |       | 1,854     |       | 3,974            |       | 6,719        |       |
| Interest and  fees expense — affiliate     |       | —    |       | —    |       | —    |       | (142             | )          | (142         | )          |
| Interest and  fees expense — other         |       | (146      | )          | (160      | )          | (199      | )          | (592             | )          | (1,097       | )          |
| Provision for  loan and impairment losses       |       | 26        |       | 120       |       | 126       |       | (869             | )          | (597         | )          |
| Service fees —  affiliate                  |       | (70       | )          | (35       | )          | (234      | )          | (525             | )          | (864         | )          |
| General,  administrative and operating expenses |       | (79       | )          | (67       | )          | (38       | )          | (602             | )          | (786         | )          |
| Expenses                                        |       | (269      | )          | (142      | )          | (345      | )          | (2,730           | )          | (3,486       | )          |
| Net earnings                                    |       | $         | 310        |      | $          | 170       |       | $                | 1,509      |         | $          | 1,244 |   | $ | 3,233 |   |

 

**Three Months EndedSeptember 30, 2005**
| ** **                                      | ** ** | **WAMCO** | ** ** | **WAMCO** | ** ** | **WAMCO** | ** ** | **Other**        | ** ** | ** **   | ** ** |
|-------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|------------------|------------|--------------|------------|
| ** **                                      | ** ** | **30**    | ** ** | **31**    | ** ** | **33**    | ** ** | **Partnerships** | ** ** | **Combined** | ** ** |
| Income from  Portfolio Assets                   |       | $         | 475        |      | $          | 407       |       | $                | 1,900      |         | $          | 1,775 |   | $ | 4,557 |   |
| Other income,  net                              |       | 5         |       | 8         |       | —    |       | 21               |       | 34           |       |
| Revenues                                        |       | 480       |       | 415       |       | 1,900     |       | 1,796            |       | 4,591        |       |
| Interest and  fees expense — affiliate     |       | —    |       | —    |       | —    |       | (225             | )          | (225         | )          |
| Interest and  fees expense — other         |       | (15       | )          | (281      | )          | (443      | )          | (10              | )          | (749         | )          |
| Provision for  loan and impairment losses       |       | (52       | )          | —    |       | 169       |       | (52              | )          | 65           |       |
| Service fees —  affiliate                  |       | (81       | )          | (76       | )          | (287      | )          | (254             | )          | (698         | )          |
| General,  administrative and operating expenses |       | (75       | )          | (61       | )          | (192      | )          | (577             | )          | (905         | )          |
| Expenses                                        |       | (223      | )          | (418      | )          | (753      | )          | (1,118           | )          | (2,512       | )          |
| Net earnings  (loss)                            |       | $         | 257        |      | $          | (3        | )          | $                | 1,147      |         | $          | 678 |   | $ | 2,079 |   |

 

14

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**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in Thousands,except per share data)—(continued)**

**Nine Months EndedSeptember 30, 2006**
| ** **                                      | ** ** | **WAMCO** | ** ** | **WAMCO** | ** ** | **WAMCO** | ** ** | **Other**        | ** ** | ** **   | ** ** |
|-------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|------------------|------------|--------------|------------|
| ** **                                      | ** ** | **30**    | ** ** | **31**    | ** ** | **33**    | ** ** | **Partnerships** | ** ** | **Combined** | ** ** |
| Income from  Portfolio Assets                   |       | $         | 1,995      |      | $          | 1,524     |       | $                | 4,418      |         | $          | 11,825 |   | $ | 19,762 |   |
| Other income,  net                              |       | 18        |       | 30        |       | 48        |       | 1,360            |       | 1,456        |       |
| Revenues                                        |       | 2,013     |       | 1,554     |       | 4,466     |       | 13,185           |       | 21,218       |       |
| Interest and  fees expense — affiliate     |       | —    |       | —    |       | —    |       | (467             | )          | (467         | )          |
| Interest and  fees expense — other         |       | (200      | )          | (584      | )          | (823      | )          | (814             | )          | (2,421       | )          |
| Provision for  loan and impairment losses       |       | (41       | )          | —    |       | (60       | )          | (1,726           | )          | (1,827       | )          |
| Service fees —  affiliate                  |       | (268      | )          | (225      | )          | (677      | )          | (1,871           | )          | (3,041       | )          |
| General,  administrative and operating expenses |       | (287      | )          | (133      | )          | (335      | )          | (2,169           | )          | (2,924       | )          |
| Expenses                                        |       | (796      | )          | (942      | )          | (1,895    | )          | (7,047           | )          | (10,680      | )          |
| Net earnings                                    |       | $         | 1,217      |      | $          | 612       |       | $                | 2,571      |         | $          | 6,138 |   | $ | 10,538 |   |

 

**Nine Months EndedSeptember 30, 2005**
| ** **                                      | ** ** | **WAMCO** | ** ** | **WAMCO** | ** ** | **WAMCO** | ** ** | **Other**        | ** ** | ** **   | ** ** |
|-------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|------------------|------------|--------------|------------|
| ** **                                      | ** ** | **30**    | ** ** | **31**    | ** ** | **33**    | ** ** | **Partnerships** | ** ** | **Combined** | ** ** |
| Income from  Portfolio Assets                   |       | $         | 1,775      |      | $          | 3,051     |       | $                | 5,355      |         | $          | 11,334 |   | $ | 21,515 |   |
| Other income, net                               |       | 10        |       | 22        |       | —    |       | 52               |       | 84           |       |
| Revenues                                        |       | 1,785     |       | 3,073     |       | 5,355     |       | 11,386           |       | 21,599       |       |
| Interest and  fees expense — affiliates    |       | —    |       | —    |       | (893      | )          | (652             | )          | (1,545       | )          |
| Interest and  fees expense — other         |       | (166      | )          | (911      | )          | (592      | )          | (81              | )          | (1,750       | )          |
| Provision for  loan losses                      |       | (109      | )          | —    |       | (506      | )          | (223             | )          | (838         | )          |
| Service fees —  affiliate                  |       | (264      | )          | (435      | )          | (664      | )          | (1,134           | )          | (2,497       | )          |
| General,  administrative and operating expenses |       | (320      | )          | (253      | )          | (435      | )          | (4,255           | )          | (5,263       | )          |
| Expenses                                        |       | (859      | )          | (1,599    | )          | (3,090    | )          | (6,345           | )          | (11,893      | )          |
| Net earnings                                    |       | $         | 926        |      | $          | 1,474     |       | $                | 2,265      |         | $          | 5,041 |   | $ | 9,706 |   |

 

Statements of operations for MinnTex Investment Partners LP for the threeand nine month periods ended September 30, 2006 and 2005 follow:

|                                                 | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                      | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                      | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Income from  Portfolio Assets                   |       | $                                | 353        |                            | $          | 988 |   | $ | 1,239 |   | $ | 4,090 |   |
| Other income                                    |       | —                           |       | 3                               |       | 3 |   | 8 |   |
| Revenues                                        |       | 353                              |       | 991                             |       | 1,242 |   | 4,098 |   |
| Service fees —  affiliate                  |       | (30                              | )          | (86                             | )          | (111 | ) | (402 | ) |
| General,  administrative and operating expenses |       | (2                               | )          | (5                              | )          | (13 | ) | (20 | ) |
| Expenses                                        |       | (32                              | )          | (91                             | )          | (124 | ) | (422 | ) |
| Net earnings                                    |       | $                                | 321        |                            | $          | 900 |   | $ | 1,118 |   | $ | 3,676 |   |

 

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 primary beneficiary of any of these entities based on the criteria setforth in FIN 46R. At September 30, 2006, FirstCity’s maximum exposure to lossas a result of its involvement with the VIEs is $24.2 million.

At September 30, 2006, the Company had $16.0 millionin Euro-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 bycorresponding changes in the values of the Euro-denominated debt.

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**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in Thousands,except per share data)—(continued)**

Effectiveness of the hedging relationship is measuredand designated at the beginning of each month by comparing the outstandingbalance of the Euro-denominated debt to the carrying value of the designatednet equity investments. The net foreign currency translation gain (loss)included in accumulated other comprehensive income relating to theEuro-denominated debt was ($1.7) million for the nine months ended September30, 2006 and $1.2 million for the same period in 2005.

During the third quarter of 2006 FirstCity completed atotal restructure of its investments in Mexico in a transaction which alignedFirstCity with American International Group, Inc.  FirstCity received a payment of approximately$2 million of consulting fees and recorded a gain on sale of $1.1 million inthe third quarter from the sale of certain assets by Cargill Financial ServicesInternational, Inc. and FirstCity affiliates as a result of this restructure.The net impact for the quarter from this transaction was $2.2 million net ofexpenses and intercompany eliminations. Subsequent to this transaction, Bidmex Holding LLC now owns 100% of therelated Mexican investments, and FirstCity has a 9% senior and 6% subordinatedequity investment in Bidmex Holding LLC. The Company will evaluate the subordinated investment for impairmentquarterly.

**(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 nine months ended September 30, 2006 and 2005.
| ** **                                                                         | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                         | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                                         | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Portfolio  Asset Acquisition and Resolution:**                                   | ** ** | ** **                       |       |                            | ** ** | ** ** |   |   |   |
| Revenues:                                                                          |       |                             |       |                            |       |   |   |   |   |
| Servicing fees                                                                     |       | $                                | 4,679      |                            | $          | 2,891 |   | $ | 10,182 |   | $ | 8,972 |   |
| Income from Portfolio Assets                                                       |       | 2,547                            |       | 2,124                           |       | 7,551 |   | 6,269 |   |
| Interest income from affiliates                                                    |       | 294                              |       | 420                             |       | 1,189 |   | 1,293 |   |
| Interest income from loans receivable - other                                      |       | 17                               |       | —                          |       | 17 |   | — |   |
| Other                                                                              |       | 281                              |       | 141                             |       | 1,113 |   | 718 |   |
| Total                                                                              |       | 7,818                            |       | 5,576                           |       | 20,052 |   | 17,252 |   |
| Expenses:                                                                          |       |                             |       |                            |       |   |   |   |   |
| Interest and fees on notes payable                                                 |       | 1,799                            |       | 918                             |       | 5,455 |   | 2,646 |   |
| Salaries and benefits                                                              |       | 3,120                            |       | 2,852                           |       | 8,557 |   | 9,039 |   |
| Provision (recovery) for loan and impairment losses                                |       | 50                               |       | 322                             |       | 101 |   | 436 |   |
| Occupancy, data processing, communication and other                                |       | 2,002                            |       | 1,223                           |       | 4,194 |   | 3,522 |   |
| Minority interest                                                                  |       | (2                               | )          | (3                              | )          | (64 | ) | 36 |   |
| Total                                                                              |       | 6,969                            |       | 5,312                           |       | 18,243 |   | 15,679 |   |
| Equity in earnings of investments                                                  |       | 3,023                            |       | 1,783                           |       | 8,044 |   | 8,874 |   |
| Gain on sale of interest in equity investments                                     |       | 2,378                            |       | —                          |       | 2,405 |   | — |   |
| Operating contribution before direct taxes                                         |       | $                                | 6,250      |                            | $          | 2,047 |   | $ | 12,258 |   | $ | 10,447 |   |
| Operating contribution, net of direct taxes                                        |       | $                                | 6,218      |                            | $          | 2,020 |   | $ | 12,095 |   | $ | 10,263 |   |
|                                                                               |       |                             |       |                            |       |   |   |   |   |
| **Corporate  Overhead:**                                                           |       |                             |       |                            |       |   |   |   |   |
| Salaries and benefits, occupancy, professional and  other income and expenses, net |       | 1,251                            |       | 1,328                           |       | 3,768 |   | 4,202 |   |
| Earnings from  continuing operations                                               |       | $                                | 4,967      |                            | $          | 692 |   | $ | 8,327 |   | $ | 6,061 |   |

 

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**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in Thousands,except per share data)—(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** | ** ** | **Nine Months Ended** | ** ** |
|---------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **    | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **    | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Domestic      |       | $                                | 4,953      |                            | $          | 4,692 |   | $ | 16,344 |   | $ | 15,418 |   |
| Canada        |       | 17                               |       | —                          |       | 17 |   | — |   |
| Latin America |       | 4,761                            |       | 2,088                           |       | 7,902 |   | 7,458 |   |
| Europe        |       | 1,110                            |       | 579                             |       | 3,833 |   | 3,250 |   |
| Total         |       | $                                | 10,841     |                            | $          | 7,359 |   | $ | 28,096 |   | $ | 26,126 |   |

 

Total assets for the Portfolio Asset acquisition and resolution segmentand a reconciliation to total assets are as follows:

|                                                   | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                        | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| Cash                                              |       | $                      | 13,036     |                  | $          | 12,901 |   |
| Portfolio acquisition  and resolution assets:     |       |                   |       |                  |       |
| Domestic                                          |       | 115,349                |       | 105,938               |       |
| Latin America                                     |       | 28,220                 |       | 19,764                |       |
| Europe                                            |       | 27,463                 |       | 27,699                |       |
| Loans receivable  and interest receivable - other |       | 2,309                  |       | —                |       |
| Deferred tax asset, net                           |       | 20,101                 |       | 20,101                |       |
| Other non-earning  assets, net                    |       | 6,877                  |       | 8,309                 |       |
| Discontinued mortgage  assets                     |       | 103                    |       | 157                   |       |
| Total assets                                      |       | $                      | 213,458    |                  | $          | 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** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                        | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                                        | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                        | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                        | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Earnings from  continuing operations                                              |       | $                                | 4,967      |                            | $          | 692 |   | $ | 8,327 |   | $ | 6,061 |   |
| Weighted average  outstanding shares of common stock                              |       | 11,104                           |       | 11,298                          |       | 11,239 |   | 11,278 |   |
| Dilutive effect of:                                                               |       |                             |       |                            |       |   |   |   |   |
| Warrants                                                                          |       | 328                              |       | 340                             |       | 336 |   | 343 |   |
| Employee stock  options                                                           |       | 279                              |       | 370                             |       | 300 |   | 391 |   |
| Weighted average  outstanding shares of common stock and common stock equivalents |       | 11,711                           |       | 12,008                          |       | 11,875 |   | 12,012 |   |
| Earnings from  continuing operations per share:                                   |       |                             |       |                            |       |   |   |   |   |
| Basic                                                                             |       | $                                | 0.45       |                            | $          | 0.06 |   | $ | 0.74 |   | $ | 0.54 |   |
| Diluted                                                                           |       | $                                | 0.42       |                            | $          | 0.05 |   | $ | 0.70 |   | $ | 0.50 |   |

 

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**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in Thousands,except per share data)—(continued)**

**(9)  Stock-Based Compensation**

The Company has stock option and award plans for thebenefit of key individuals, including its directors, officers and keyemployees. The plans are administered by a committee of the Board of Directorsand provide for the grant of up to a total of 800,000 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 their terms, with existing options remaining in accordance with theterms of each grant.  Stock option awardsare granted with an exercise price equal to the market price of FirstCity’sshares at the date of grant; those stock option awards generally vest 25% eachyear from the date of grant and have 10-year contractual terms.  Certain stock options issued to non-employeedirectors were exercisable immediately.

FirstCity adopted SFAS123(R) using the modified prospective transition method beginning January 1,2006. Accordingly, during the three and nine month periods ended September 30,2006, the Company recorded stock-based compensation expense for awards grantedprior to, but not yet vested as of January 1, 2006, as if the fair value methodrequired for pro forma disclosure under SFAS 123 were in effect for expenserecognition purposes, adjusted for estimated forfeitures. For these awards, werecognized compensation expense using the straight-line amortization method.For stock-based awards granted after January 1, 2006, the Company recognizescompensation expense based on the estimated grant date fair value method usingthe Black-Scholes valuation model. For these awards, FirstCity recognizescompensation 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 ninemonth periods ended September 30, 2006 has been reduced for estimatedforfeitures. When estimating forfeitures, FirstCity considers voluntarytermination behaviors as well as trends of actual option forfeitures. Theimpact on the results of operations of recording stock-based compensation forthe three and nine month periods ended September 30, 2006 and 2005 was asfollows:

|                                                   | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                        | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                        | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Amount of compensation  cost recognized in income |       | $                                | 221        |                            | $          | — |   | $ | 467 |   | $ | — |   |
| 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 nine monthperiods ended September 30, 2006 and 2005 was $68 and $162, 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.  The following assumptions were used for eachrespective period:

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**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in Thousands,except per share data)—(continued)**

|                                         | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                              | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                              | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Weighted average grant date  fair value | ** ** | $                                | 6.71       | ** **                      | $          | — |   | $ | 6.71 |   | $ | — |   |
| Volatility                              |       | 82                               | %          | 0                               | %          | 82 | % | 0 | % |
| Risk-free interest rate                 |       | 4.88                             | %          | 0.00                            | %          | 4.88 | % | 0.00 | % |
| Expected life in years                  |       | 5                                |       | 0                               |       | 5 |   | 0 |   |
| Dividend yield                          |       | Zero                             |       | Zero                            |       | Zero |   | Zero |   |
|                                         |            |                                  |            |                                 |            |  |  |  |  |  |  |  |  |

 

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

|                                    | ** ** | ** ** | ** ** | ** **   | ** ** | **Weighted**    | ** ** | ** **    | ** ** |
|------------------------------------|------------|------------|------------|--------------|------------|-----------------|------------|---------------|------------|
| ** **                         | ** ** | ** ** | ** ** | ** **   | ** ** | **Average**     | ** ** | ** **    | ** ** |
| ** **                         | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Remaining**   | ** ** | ** **    | ** ** |
| ** **                         | ** ** | ** ** | ** ** | **Average**  | ** ** | **Contractual** | ** ** | **Aggregate** | ** ** |
| ** **                         | ** ** | ** ** | ** ** | **Exercise** | ** ** | **Term**        | ** ** | **Intrinsic** | ** ** |
| ** **                         | ** ** | **Shares** | ** ** | **Price**    | ** ** | **(Years)**     | ** ** | **Value**     | ** ** |
| Outstanding at January  1, 2006    |       | 755,850    |       | $            | 7.02       |            |       |          |       |   |
| Granted                            |       | 35,000     |       | 9.84         |       |            |       |          |       |
| Exercised                          |       | (9,750     | )          | 6.93         |       |            |       |          |       |
| Expired                            |       | —     |       | —       |       |            |       |          |       |
| Forfeited                          |       | (2,000     | )          | 27.25        |       |            |       |          |       |
| Outstanding at September  30, 2006 |       | 779,100    |       | $            | 7.10       |            | 6.26       |          | $          | 3,538 |   |
| Exercisable at September 30, 2006  |       | 550,450    |       | $            | 6.23       |            | 5.34       |          | $          | 3,130 |   |

 

The total intrinsic value of stock options exercisedduring the three and nine month periods ended September 30, 2006 were $16 and$36, respectively.  The total intrinsicvalue of stock options exercised during the three and nine month periods endedSeptember 30, 2005 were $29 and $322, respectively.  As of September 30, 2006, there wasapproximately $1.2 million of total unrecognized compensation cost related tounvested share-based compensation arrangements granted under the stock optionplans.  That cost is expected to berecognized over a weighted average period of 2.3 years.

A summary of the status and changes of FirstCity’snonvested shares as of September 30, 2006, and changes during the nine monthsended September 30, 2006 is presented below:

|                                 | ** ** | ** ** | ** ** | **Weighted-**       | ** ** |
|---------------------------------|------------|------------|------------|---------------------|------------|
| ** **                      | ** ** | ** ** | ** ** | **Average**         | ** ** |
| ** **                      | ** ** | ** ** | ** ** | **Grant-Date**      | ** ** |
| ** **                      | ** ** | **Shares** | ** ** | **Fair Value** | ** ** |
| Nonvested at January 1,  2006   |       | 253,525    |       | $                   | 6.58       |   |
| Granted                         |       | 35,000     |       | $                   | 6.71       |   |
| Vested                          |       | (59,875    | )          | $                   | 5.52       |   |
| Forfeited                       |       | —     |       | —              |       |
| Nonvested at September 30, 2006 |       | 228,650    |       | $                   | 6.88       |   |

 

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 compensation expenserecognized under SFAS 123(R) was not reflected in the results of operations forthe three and nine month periods ended September 30,

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**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in Thousands,except per share data)—(continued)**

2005 for employee stock option awards, as all optionswere granted with an exercise price equal to the market value of the underlyingcommon stock on the date of grant. Forfeitures of awards were recognized asthey occurred. Previously reported amounts have not been restated.

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

|                                                                                                                                             | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                                                  | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                                                                                                  | ** ** | **2005**                         | ** ** | **2005**                        | ** ** |
| Net earnings to common  stockholders, as reported                                                                                           |       | $                                | 1,011      |                            | $          | 6,283 |   |
| Less: Total  stock-based employee compensation expense determined under fair value based  method for all awards, net of related tax effects |       | (76                              | )          | (226                            | )          |
| Pro forma net earnings  to common stockholders                                                                                              |       | $                                | 935        |                            | $          | 6,057 |   |
| Net earnings per common  share:                                                                                                             |       |                             |       |                            |       |
| Basic — as reported                                                                                                                    |       | $                                | 0.09       |                            | $          | 0.56 |   |
| Basic — pro forma                                                                                                                      |       | $                                | 0.08       |                            | $          | 0.54 |   |
| Diluted — as reported                                                                                                                  |       | $                                | 0.08       |                            | $          | 0.52 |   |
| Diluted — pro forma                                                                                                                    |       | $                                | 0.08       |                            | $          | 0.50 |   |

 

**(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. Theultimate realization of the resulting net deferred tax asset is dependent upongenerating sufficient taxable income from its continuing operations prior toexpiration 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.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.

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 Contributionand Assumption Agreement by and between Consumer Corp. and Drive, and aContribution and Assumption Agreement by and between Funding LP and Drive(collectively, the “Contribution Agreements”). Drive assumed substantially allof the liabilities of the automobile finance operation as set forth in theContribution Agreements.  In addition,pursuant to the terms of a Securities Purchase Agreement dated as of August 18,2000 (the “2000 Securities Purchase Agreement”), by and among FirstCity,Consumer Corp., Funding LP, and FirstCity Funding GP Corp. (“Funding GP”), IFADrive GP Holdings LLC (“IFA-GP”) and IFA Drive LP Holdings LLC (“IFA-LP”);FirstCity, Consumer Corp., Funding LP and Funding GP made various warrantiesconcerning (i) their respective organizations, (ii) the automobile financeoperation conducted by Consumer Corp. and Funding LP, and (iii) the assetstransferred by Consumer Corp. and Funding LP to Drive. The Company, ConsumerCorp., Funding LP and Funding GP also agreed to indemnify BoS (USA), IFA-GP andIFA-LP from damages resulting from a breach of any representation or warrantycontained in the 2000 Securities Purchase Agreement or otherwise made by theCompany, Consumer Corp. or Funding LP in connection with the transaction. Allindemnity obligations under the 2000 Securities Purchase Agreement terminated

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**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in Thousands,except per share data)—(continued)**

after thirty (30) months, with the exception oftax-related representations and warranties which survive for a period of seven(7) years from August 25, 2000 (the “2000 Closing Date”). Neither the Company,Consumer Corp., Funding LP, or Funding GP is required to make any payments as aresult of the indemnity provided under the 2000 Securities Purchase Agreementuntil the aggregate amount payable exceeds $.25 million, and then only for theamount in excess of $.25 million in the aggregate; however certainrepresentations and warranties are not subject to this $.25 millionthreshold.  Management of the Companybelieves that FirstCity will not have to pay any amounts related to theseagreements.

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 fromdamages resulting from a breach of any representation or warranty contained inthe 2004 Securities Purchase Agreement or otherwise made by FirstCity, ConsumerCorp. or Funding LP in connection with the transaction. The indemnityobligations under the 2004 Securities Purchase Agreement survive for a maximumperiod of five (5) years from November 1, 2004. Neither FirstCity, ConsumerCorp., Funding LP, or Funding GP is required to make any payments as a resultof the indemnity provided under the 2004 Securities Purchase Agreement untilthe aggregate amount payable exceeds $.25 million, and then only for the amountin excess of $.25 million in the aggregate; however, certain representationsand warranties are not subject to this $.25 million threshold. Managementof the Company believes that FirstCity will not have to pay any amountsrelating to these representations and warranties.

FirstCity has minority interests in variouslimited-life partnerships with a carrying value of $.8 million at September 30,2006. The estimated amount that would be paid to the minority interest holderif the instruments were to be settled at September 30, 2006 is $2.6 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.

During the period from December 1998 to March 2005,FirstCity Mexico, Inc. and Strategic Mexican Investment Partners, L.P. (“SMIP”),each affiliates of FirstCity and Cargill Financial Services International, Inc.(“CFSI”) and, in some instances, other investors, acquired 12 residential andcommercial non-performing loan portfolios from financial institutions in Mexico(the “Mexican Portfolios”).  Eachportfolio was acquired by a Mexican limited liability company (each a “MexicanSRL”) that was owned by a Delaware limited liability company formed by eachinvestor group.  On August 8, 2006, SMIPand National Union Fire Insurance Company of Pittsburgh, Pa., American GeneralLife Insurance Company and American General Life and Accident InsuranceCompany, affiliates of AIG Global Asset Management Holdings Corp. (collectivelythe “AIG Entities”) formed Bidmex Holding, LLP for the purpose of acquiring theMexican Portfolios by purchasing the interests of Cargill and SMIP in eleven ofthe Mexican limited liability companies (the “LLCs”) and purchasing the loanportfolio of one of the Mexican limited liability companies (the “PurchasedPortfolio”) for an aggregate purchase price of $1,298,820,000 Mexican Pesos,which was the equivalent of $119,258,457 U.S. Dollars as of that date (the “AggregatePurchase Price”).  SMIP acquired 15% ofthe membership interests in Bidmex Holding, LLC.  A 9% interest acquired by SMIP is ofequivalent standing to membership interests held by the AIG affiliatesrepresenting 85% of the membership interests. The remaining 6% membership interest acquired by SMIP is subordinate tothe other owners of interests in Bidmex Holding, LLC, who will receive thereturn of and a return on their contribution equivalent to an 9% internal rateof return with respect to their interests prior to SMIP receiving the return ofand a return on its capital contribution equivalent to a 9% internal rate ofreturn with respect to its 6% interest.

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**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in Thousands,except per share data)—(continued)**

Also on August 8, 2006, an Interest Purchase and SaleAgreement was entered into by and among Bidmex Holding, LLC (“Buyer”), asbuyer, and SMIP and CFSI (collectively, the “Sellers”), as seller, and elevenof the LLCs and the AIG entities as additional parties.  In the Interest Purchase and Sale Agreement,the Sellers and the LLCs made various representations and warranties concerning(i) the existence and ownership of the LLCs and the related Mexican SRLs, (ii)the assets and liabilities of the LLCs, (iii) taxes related to periods prior toAugust 8, 2006, and (iv) the operations of the LLCs and SRLs.  The Sellers agreed to indemnify the Buyer andAIG Entities from damages resulting from a breach of any representation orwarranty contained in the Interest Purchase and Sale Agreement on a several andnot joint basis according to their respective ownership percentages in each LLCas to any matter related to a particular LLC, or on the basis of 80% to CFSIand 20% to SMIP as to any matter that could not be identified to a particularLLC.  The indemnity obligation under theInterest Purchase and Sale Agreement survives for a period of the statute oflimitations for matters related to taxes, existence and authority,capitalization and good standing of the LLCs and SRLs and for a period of twoyears from August 8, 2006, the closing date with respect to all otherrepresentations and warranties.  TheSellers are not required to make any payments as a result of the indemnityprovisions of the Interest Purchase and Sale Agreement until the aggregateamount payable under that agreement and the Asset Purchase Agreement exceeds$250,000; however, claims related to taxes and fraud are not subject to this$250,000 threshold.  The InterestPurchase and Sale Agreement limits the liability of the Sellers forindemnifiable losses under the Interest Purchase and Sale Agreement and theAsset Purchase Agreement to the Aggregate Purchase Price (without duplicationof amounts recovered pursuant to the terms of the Asset Purchase Agreement).

Also on August 8, 2006, Bidmex Holding, LLC enteredinto an Agreement for the Onerous Transfer of Loans and Litigious Rights (the “AssetPurchase Agreement”) between and among Residencial Oeste, S. de R.L. de C.V.,as seller (the “Asset Seller”), an affiliate of CFSI and SMIP, ResidencialOeste 2, S. de R.L. de C.V., as purchaser (the “Asset Purchaser”), and CFSI,SMIP, and Bidmex Acquisition, LLC, the parent of the Asset Purchaser, asadditional parties.  The Asset PurchaseAgreement provides for the sale of the loan portfolio owned by the Seller tothe Purchaser for a purchase price of $109,514,735 Mexican Pesos, theequivalent of $10,055,711 on the closing date, which purchase price is part ofthe Aggregate Purchase Price.  In theAsset Purchase Agreement, the Asset Seller and the Sellers made variousrepresentations and warranties concerning (i) the existence and ownership ofthe Seller, (ii) the ownership of the loan portfolio, (iii) taxes related toperiods arising prior to the closing date, and (iv) the existence of the loanscomprising the loan portfolio and other matters related to the loanportfolio.  The Asset Seller agreed toindemnify the Asset Purchaser from damages resulting from a breach of anyrepresentation or warranty.  Theindemnity obligation under the Asset Purchase Agreement survives for a periodof the statute of limitations for matters related to existence and ownership ofthe Seller, ownership of the loans, and taxes for periods prior to August 8,2006, and for a period of two years from August 8, 2006, with respect to allother representations and warranties. The Seller is not required to make any payments as a result of theindemnity provisions of the Asset Purchase Agreement until the aggregate amountpayable under that Agreement exceeds $25,000; however, claims related to taxesand fraud are not subject to this $25,000 threshold.  The Interest Purchase and Sale Agreementlimits the liability of the Sellers for indemnifiable losses under the AssetPurchase Agreement to the Aggregate Purchase Price.

In connection with the Interest Purchase and SaleAgreement, Recuperación de Carteras Mexicanas, S. de R.L. de C.V., as optionor(“RCM”), an affiliate of SMIP and CFSI, granted a put option dated August 8,2006 to Bidmex Holding, LLC, as optionee, pursuant to the terms of a Put OptionAgreement by and among RCM, Bidmex Holding, LLC, and Bidmex 6, LLC, the parententity of RCM and SMIP.  RCM granted aput option to Bidmex Holding, LLC related to the purchase of any loan ofSolución de Activos Residenciales, S. de R.L. de C.V. or Solución de ActivosComerciales, S. de R.L. de C.V., each a Mexican SRL, if any borrowing on a loanmade by those entities has filed or files a challenge in a legal proceedingrelated to any such loan based on, in addition to any other defense claims, aclaim on grounds related to the Mexican Supreme Court Ruling that has put intoissue the actions required for transfer of loans by Mexican financialinstitutions after August 2003, provided that any such challenge is asserted onor before the earlier of (i) the reversal of the Supreme Court Ruling, or (ii)February 1, 2008.  The purchase price forany loan under the put option is to be the allocated purchase price set by theparties for the loan, plus certain expenses related to the transfer andcollection of the loan, plus any taxes paid or payable with respect to the cashflow from each loan, reduced by any cash flow received by Bidmex Holding, LLCwith respect to the loan.

Also in connection with the Interest Purchase and SaleAgreement, FirstCity entered executed a Guaranty dated as of August 8, 2006, infavor of Bidmex Holding, LLC, Asset Purchaser, and the AIG Entities, pursuantto which FirstCity guaranteed that FirstCity would cause and enable SMIP toperform its obligations under the Interest Purchase and Sale Agreement andAsset Purchase Agreement, that SMIP would perform and fulfill its obligationsunder those agreements and also that the payments provided for in thoseagreements would be promptly paid when due. FirstCity’s obligations under the Guaranty are subject to anybeneficiary obtaining judgment against SMIP regarding the performance of anyobligation for which such beneficiary is seeking FirstCity’s guaranty.

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**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in Thousands,except per share data)—(continued)**

On September 22, 2006, FirstCity NPL S.A., a Chileanaffiliate of FirstCity Chile Ltda and FirstCity, entered into a revolving lineof credit with a maximum loan amount in Chilean pesos equivalent to $10,000,000U.S. Dollars with CORPBANCA Sociedad Anónima Bancaria (“CB”) to finance thepurchase of delinquent and due accounts. The revolving line of credit was structured by Corpbanca AsesoríasFinancieras S.A. (“CAF”).  Pursuant tothe terms of the credit facility, FirstCity NPL S.A. was required to provide astand-by letter of credit from Bank of Scotland that would satisfy the loanbalance upon demand.  FirstCity obtaineda letter of credit in the amount of $8,000,000 from Bank of Scotland under theterms of FirstCity’s revolving acquisition facility with Bank of Scotland.  In the event that a demand is made under the$8,000,000 letter of credit, FirstCity is required to reimburse Bank ofScotland by making payment to Bank of Scotland for all amounts disbursed or tobe disbursed by Bank of Scotland under the letter of credit.

**(12)  Equity**

On August 14, 2006, FirstCity announced that the Boardof Directors authorized a stock repurchase plan providing for the purchase ofup to one million shares of the company’s common stock, with purchases to bemade over a period of twelve months.  Inthe third quarter of 2006, FirstCity repurchased 530,300 shares of the Company’scommon stock on the open market for a total of $5.6 million.

**(13)  Subsequent Events**

On November 1,2006, FirstCity and Bank of Scotland, as agent for the lenders, entered into anAmendment No. 4 to Revolving Credit Agreement, dated as of October 31, 2006(the “Amendment”).  The Amendment amended the existing $96,000,000revolving credit facility entered into on November 12, 2004, to increase therevolving credit facility to $175,000,000 that matures on November 12,2010.  The Amendment made the following changes to the existing loanfacility that is used to finance the senior debt and equity portion ofportfolio and asset purchases made by FirstCity and to provide for the issuanceof letters of credit and working capital loans: (i) increased the maximumoutstanding amount of loans and letters of credit issued under the loanfacility that may be outstanding under the loan facility to $175,000,000; (ii)reduced the available interest rates under the loan facility by 0.5% per annum;(iii) increased the maximum value for assets that can be included in theborrowing base from the acquisition of portfolio assets in certain countries asfollows (a) Mexico increased to $30,000,000, (b) Brazil increased to$5,000,000, (c) Chile to $10,000,000, and (d) Argentina or Uruguay to$6,000,000; (iv) increased the limit for Loans that can be borrowed in Eurosunder the loan facility to $50,000,000; (v) increased the maximum amount ofletters of credit that can be issued under the loan facility to $40,000,000;(vi) increased the maximum amount of working capital loans that can beoutstanding under the loan facility to $35,000,000; (vii) provided for anadditional upfront fee paid to Bank of Scotland in the amount of $830,000;(viii) amended the requirement for the ratio of EBITDA to Interest Coverage tobe not less than 1.50 to 1.00 for each twelve month period, and added a newcovenant that FirstCity must maintain a ratio of Cumulative Current Recoveredand Projected Collections to Cumulative Original Projected Collections of notless than 0.90 to 1.00; and (ix) extended the maturity date for the loanfacility to November 12, 2010.  The obligations of FirstCity under theRevolving Credit Agreement are guaranteed by substantially all of thewholly-owned subsidiaries of FirstCity and are secured by security interests insubstantially all of the assets of FirstCity and its wholly-owned subsidiaries.

In October 2006, FirstCity invested $16.0 million inthe form of a loan to a domestic real estate investment partnership, which willbe included on the consolidated balance sheets as loans receivable — other.

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

**Overview**

FirstCity is a financial services company engaged in the acquisition andresolution of portfolios of assets or single assets (collectively referred toas “Portfolio Assets”).  The Portfolio Assetacquisition and resolution business involves acquiring Portfolio Assets at adiscount to face value and servicing and resolving such portfolios in an effortto maximize the present value of the ultimate cash recoveries.

During the thirdquarter of 2006, the Company recorded earnings to common stockholders on adiluted basis of $5.0 million or $.42 per common share. The operatingcontribution from the Portfolio Asset acquisition and resolution segment was$6.2 million compared with $2.0 million for the same period in 2005. During thethird quarter of 2006, the Company received $2 million in consulting feesrelated to the sale of certain assets in Latin America which occurred as aresult of the restructure of the Company’s investments in Mexico. In addition,the Company recorded a gain on the sale ofequity investments of $2.4 million. This gain consisted of: 1) one domesticequity investment resulting in a gain of $1.3 million and; 2) a partial sale ofLatin American equity investments resulting in a gain of $1.1 million.

The Company invested $31.5 million in portfolioacquisitions during the quarter bringing the year to date acquisitions to $73.8million. In addition to the portfolio acquisitions during this period,FirstCity invested $1.4 million in partnerships as well as $2.3 million in theform of a loan to a Canadian real estate development company. As a result,earning assets (equity investment, inventory, loans receivable, and interestreceivable) increased to $173.3 million. 

Management remains positive on the outlook of theCompany.  The acquisitions for the quarter contributed to a $21.1 millionnet increase in the primary earning assets base of the Company and FirstCity iscurrently evaluating 33 different transactions representing over $3 billion inface value of assets.

During the thirdquarter FirstCity completed a total restructure of its investments in Mexico ina transaction which aligned FirstCity with American International Group, Inc. (“AIG”). The details of the restructure are provided in Note 6 to the ConsolidatedFinancial Statements.

Subsequent to quarter end, the Company was able to secure an increase inits revolving line of credit with the Bank of Scotland up to a maximum of $175million.  The original line of credit was$96 million and, in accordance with the terms of the agreement, had beenreduced to $90.7 million.   As a resultof the amended agreement, the net increase in availability of funds through theline of credit is $84.3 million.  Inaddition, the interest rate decreased 50 basis points.

The Company’s financial results are affected by many factors includinglevels of, and fluctuations in, interest rates, fluctuations in the underlyingvalues of real estate and other assets, the timing of, and ability to,liquidate assets, and the availability and prices for loans and assets acquiredin all of the Company’s businesses. The Company’s business and results ofoperations are also affected by the availability of financing with termsacceptable to the Company and the Company’s access to capital markets,including the securitization markets.

As a result of the significant period to period fluctuations in therevenues and earnings and losses of the Company’s Portfolio Asset acquisitionand resolution business, period to period comparisons of the Company’s resultsof continuing operations may not be meaningful.

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Components of the results for the three and nine month periods endedSeptember 30, 2006 and 2005, respectively, are detailed below (dollars inthousands except per share data):

|                                                             | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                  | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                  | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                  | ** ** | **(unaudited)**                  | ** ** | **(unaudited)**                 | ** ** |
| Portfolio Asset  Acquisition and Resolution                 |       | $                                | 6,218      |                            | $          | 2,020 |   | $ | 12,095 |   | $ | 10,263 |   |
| Corporate  overhead                                         |       | (1,251                           | )          | (1,328                          | )          | (3,768 | ) | (4,202 | ) |
| Earnings from continuing operations                         |       | 4,967                            |       | 692                             |       | 8,327 |   | 6,061 |   |
| Earnings (loss) from discontinued operations, net of  taxes |       | —                           |       | 319                             |       | (75 | ) | 222 |   |
| Net earnings to common stockholders                         |       | $                                | 4,967      |                            | $          | 1,011 |   | $ | 8,252 |   | $ | 6,283 |   |
| Diluted earnings  per common share                          |       | $                                | 0.42       |                            | $          | 0.08 |   | $ | 0.69 |   | $ | 0.52 |   |

 

**Results ofOperations**

The following discussion and analysis is based on the segment reportinginformation presented in note 7 of the Consolidated Financial Statements of theCompany and should be read in conjunction with the Consolidated FinancialStatements (including the Notes thereto) included elsewhere in this QuarterlyReport on Form 10-Q.

***Third Quarter 2006 Compared to Third Quarter 2005***

The Company reported net earnings of $5.0 million in the third quarter of2006 compared to $1.0 million in the third quarter of 2005. On a per sharebasis, diluted net earnings to common stockholders were $.42 in the thirdquarter of 2006 compared to $.08 in the third quarter of 2005.

*PortfolioAsset Acquisition and Resolution*

The operating contribution from the Portfolio Asset acquisition andresolution segment was $6.2 million in the third quarter of 2006 compared to$2.0 million in the third quarter of 2005. FirstCity invested $31.5 million inPortfolio acquisitions during the third quarter of 2006, of which $8.2 millionand $23.3 million were acquired through Acquisitions Partnerships andwholly-owned Portfolios, respectively, compared to $18.1 million in the thirdquarter of 2005, which was comprised of $14.7 million through AcquisitionPartnerships and $3.4 million through wholly-owned Portfolios.  The quarter-end investment in PortfolioAssets increased to $78.9 million at September 30, 2006, from $43.2 million atSeptember 30, 2005, as a result of acquisitions of approximately $56.0 millionsince the third quarter of 2005. In addition to the portfolio acquisitionsduring the third quarter of 2006, FirstCity invested $2.3 million in the formof a loan to a Canadian real estate development company.

*Servicing fee revenues. *Servicing fee revenues increased to $4.7 millionin the third quarter of 2006 compared to $2.9 million in the third quarter of2005 primarily due to a payment of $2.0 million from the sale of a portfolio inLatin America.

*Income from Portfolio Assets*.  Income from Portfolio Assetsincreased to $2.5 million in the third quarter of 2006 from $2.1 million in thethird quarter of 2005 due to increased purchases of portfolio assets and an increasein the resolution of portfolio assets. FirstCity’s average investment in wholly owned domestic portfolio assetswas $62 million and $42.8 million during the third quarters of 2006 and 2005,respectively.

* Interest income fromaffiliates. *Interest income from affiliates decreased to $.3million in the third quarter of 2006 from $.42 million in the third quarter of2005 due to the conversion of loans to equity as part of the restructure of investmentsin Mexico.

*Other income*.Other income increased to $.28 million in the third quarter of 2006 from $.1million in the third quarter of 2005 primarily due to a reduction in theestimated carrying value of loans payable to certain members of management by$.16 million.

*Expenses. *Operating expenses were $7.0 million and $5.3million in the third quarters of 2006 and 2005, respectively.  Below is a discussion of the majorcomponents.

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Interest and fees on notes payable were $1.8 million and $.9 million inthe third quarters of 2006 and 2005, respectively. The average debt for thequarter increased to $84.9 million in the third quarter of 2006 from $52.4million in the third quarter of 2005, and the average cost of borrowingincreased to 8.47% in 2006 compared to 7.0% in 2005.

Salaries and benefits increased 9% to $3.1 million in the third quarterof 2006 from $2.9 million in the third quarter of 2005. The total number ofpersonnel within the Portfolio Asset acquisition and resolution segment were176 and 202 at September 30, 2006 and 2005, respectively.

The provision for loan and impairment losses was $50,000 and $322,000 atSeptember 30, 2006 and 2005, respectively.

Occupancy, data processing, communication and other expenses increased to$2.0 million for the third quarter of 2006 from $1.2 million in the thirdquarter of 2005 primarily due to increased legal fees related to therestructure of the Mexican Investment Platform.

Minority interest was minimal from period to period.

*Equity in earnings of investments. *Equity in earningsof investments increased 69.5% to $3.0 million in the third quarter of 2006compared to $1.8 million in the third quarter of 2005.  Equity earnings in Acquisition Partnershipsincreased 51.5% to $3.0 million in the third quarter of 2006 from $2.0 millionin the third quarter of 2005. Following is a discussion of equity earnings fromAcquisition Partnerships by geographic region.

·             *Domestic* — Equity in earnings of domestic AcquisitionPartnerships was $1.3 million in the third quarter of 2006 compared to $1.8million in the third quarter of 2005.  These partnerships reflected netearnings of $3.1 million in the third quarter of 2006 compared to $3.6 millionin 2005.  Income from Portfolio Assets in 2005 was generated primarilyfrom loans acquired prior to 2005, whereas income in 2006 was generatedprimarily from loans acquired after 2004.  Although collections onPortfolio Assets increased to $28 million in the third quarter of 2006 from $20million in 2005, income from Portfolio Assets acquired after 2004 is lesssensitive to collections than from Portfolio Assets acquired prior to 2005. For Portfolios acquired after 2004, income is recognized ratably over theremaining life of the Portfolio based on an expected yield.  Fornonperforming loans acquired prior to 2005, income is recognized to the extentthat collections exceed a pro rata portion of allocated cost from the pool.

·             *Latin America* — Equityin earnings of Acquisition Partnerships located in Latin America (primarilyMexico) were $.8 million in the third quarter of 2006 compared to equity inlosses of $.4 million in 2005.  These partnershipsreflected net earnings of $6.3 million in the third quarter of 2006 compared tonet losses of $7.5 million in 2005. The partnerships recorded $4.7 million offoreign exchange gains in the third quarter of 2006 compared to $.1 million offoreign exchange gains in 2005 (of which $.8 million gains and $.03 milliongains were included in equity earnings, respectively). During the third quarterof 2006, the partnerships recorded provisions net of recoveries of allowancefor loan losses of $.35 million compared to $5.2 million during the thirdquarter of 2005.  Interest expense of$3.6 million and $2.5 million were recorded in the third quarter of 2006 and2005, respectively. This interest is owed to affiliates of the investors ofthese partnerships, of which FirstCity recorded $.16 million and $.4 million asinterest income in the third quarters of 2006 and 2005, respectively.  FirstCity eliminated substantially all of itsloans receivable from the Mexican acquisition partnerships as a result of therestructure of the Mexican Investment Platform during the third quarter of2006.

·             *Europe* — Equity inearnings of Acquisition Partnerships located in Europe increased to $.9 millionin the third quarter of 2006 compared to $.6 million in 2005 primarily due to collectionsrelated to portfolio assets acquired in the fourth quarter of 2005. FirstCityrecorded $.12 million and $.2 million in foreign currency transaction gains(included in other expenses) relating to investments in Europe during the thirdquarter of 2006 and 2005, respectively.

*Gain on sale of equity investments.*  Gain onsale of equity investments of $2.4 million was recorded in the third quarter of2006. This gain consisted of: 1) the sale of one domestic equity investmentresulting in a gain of $1.3 million and; 2) a partial sale of twelve LatinAmerican equity investments to AIG resulting in a gain of $1.1 million inaccordance with the restructuring of the investments in Mexico.

*Other ItemsAffecting Operations*

The following items affect the Company’s overall results of operationsand are not directly related to the Portfolio Asset acquisition and resolutionbusiness discussed above.

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

*Income taxes. *Provision for incometaxes was ($4,000) and $79,000 in the third quarters of 2006 and 2005,respectively, and related primarily to state income taxes during both periods.During the third quarter of 2006, the accrual rate for state and federal incometaxes was adjusted to reflect lower anticipated payments.  Federalincome taxes are provided at a 35% rate applied to taxable income or loss andare offset by NOLs that the Company believes are available. The tax benefit ofthe NOLs is recorded in the period during which the benefit is realized. TheCompany recorded no deferred tax provision in the third quarters of either 2006or 2005.

*Discontinued Operations. *There were no additional losses from discontinuedmortgage operations during the third quarter of 2006 compared to $.3 million inthe third quarter of 2005. At September 30, 2006, the only asset remaining fromdiscontinued mortgage operations is an investment security resulting from theretention of a residual interest in a securitization transaction.

Earnings from discontinued consumer operations were $.6 million in thethird quarter of 2005, which reflects the reversal of estimated state taxprovisions related to the sale of Drive.

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

The Company reported earnings from continuing operations of $8.3 millionin the first nine months of 2006 compared to $6.1 for the same period of 2005.Net earnings to common stockholders were $8.3 million in the first nine monthsof 2006 compared to $6.3 million in the first nine months of 2005. On a pershare basis, diluted net earnings to common stockholders were $.69 in the firstnine months of 2006 compared to $.52 in the first nine months of 2005.

*PortfolioAsset Acquisition and Resolution*

The operating contribution in the first nine months of 2006 was $12.1million compared to $10.3 million for the same period last year.  FirstCity purchased $159.1 million ofPortfolio Assets during the first nine months of 2006 ($105.0 million throughAcquisition Partnerships), compared to $63.9 million in acquisitions in thefirst nine months of 2005.  FirstCity’sinvestment in these acquisitions was $73.8 million and $36.4 million in thefirst nine months of 2006 and 2005, respectively.  FirstCity’s investment in wholly-ownedPortfolio Assets increased to $78.9 million from $43.2 million at September 30,2006 and 2005, respectively.

*Servicing fee revenues. *Servicing fee revenues increased 13.5% to $10.2million in the first nine months of 2006 from $9.0 million in the first ninemonths of 2005. Service fees from the Mexican partnerships increased by $1.1million, or 18%, as a result of $2.0 million received from the sale of certainassets in Latin America which occurred as a result of the restructure of the Company’sinvestments in Mexico, offset by efforts to reduce operating costs inMexico.  For the Mexican AcquisitionPartnerships, FirstCity earns a servicing fee based on costs of servicing plusa profit margin.  Service fees from thedomestic Acquisition Partnerships increased slightly to $2.8 million in thefirst nine months of 2006 compared to $2.7 million in the same period in 2005.

*Income from Portfolio Assets. *Income from Portfolio Assets increased 20.4% to$7.6 million in the first nine months of 2006 compared to $6.3 million in thefirst nine months of 2005, primarily due to increased resolution of portfolioassets. FirstCity’s average investment in wholly-owned domestic portfolioassets was $54.1 million and $38.7 million during the first nine months of 2006and 2005, respectively.

*Interest income from affiliates. *Interest incomefrom affiliates decreased slightly to $1.2 million in the first nine months of2006 and $1.3 million in the first nine months of 2005.

*Other income. *Other income was $1.1 million in the first ninemonths of 2006 compared to $.7 million in 2005, primarily due to a reduction inthe estimated carrying value of loans payable to certain members of managementby $.3 million.

*Expenses. *Operating expenses were $18.2 million in thefirst nine months of 2006 compared to $15.7 million in the first nine months of2005.  The following is a discussion ofthe major components.

Interest and feeson notes payable increased to $5.5 million inthe first nine months of 2006 from $2.6 million in the first nine months of 2005. The average debt for the periodincreased to $87.0 million in the first nine months of 2006 from $51.2 millionin the first nine months of 2005, and the average cost of borrowing increasedto 8.36% in 2006 from 6.9% in 2005.

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Salaries and benefits decreased to $8.6 million in the first nine monthsof 2006 from $9.0 million in the first nine months of 2005. Total personnelwithin the Portfolio Asset acquisition and resolution segment were 176 and 202at September 30, 2006 and 2005, respectively.

The provision for loan and impairment losses was $.10 million in thefirst nine months of 2006 compared to $.44 million in 2005.

Occupancy, data processing, communication and other expenses increased to$4.2 million in the first nine months of 2006 compared to $3.5 million in thefirst nine months of 2005 primarily due to increased legal fees related to therestructure of the Mexican Investment Platform.

*Equity in earnings of investments. *Equity in earningsof investments decreased 9% to $8.0 million in the first nine months of 2006compared to $8.9 million in the first nine months of 2005. Equity earnings inAcquisition Partnerships decreased 7% to $7.8 million in the first nine monthsof 2006 from $8.4 million in the first nine months of 2005. Equity in earningsof servicing entities decreased 52% to $.2 million in the first nine months of2006 from $.5 million in the first nine months of 2005.  Following is a discussion of equity earningsin Acquisition Partnerships by geographic region.  See note 6 to the consolidated financialstatements for a summary of revenues and earnings of the AcquisitionPartnerships and equity in earnings of the Acquisition Partnerships.

·             *Domestic* — Equityin earnings of domestic Acquisition Partnerships decreased 14.5% to $5.1million in the first nine months of 2006 from $6.0 million in the first ninemonths of 2005 primarily as a result oftiming. These partnerships reflected net earnings of $11.1 million in the firstnine months of 2006 compared to $13.8 million in the first nine months of2005.  Income from Portfolio Assets in2005 was generated primarily from loans acquired prior to 2005, whereas incomein 2006 was generated primarily from loans acquired after 2004.  Althoughcollections on Portfolio Assets increased to $95 million in the first ninemonths of 2006 from $72 million in the first nine months of 2005, income fromPortfolio Assets acquired after 2004 is less sensitive to collections than fromPortfolio Assets acquired prior to 2005.  For Portfolios acquired after2004, income is recognized ratably over the remaining life of the Portfoliobased on an expected yield.  For nonperforming loans acquired prior to2005, income is recognized to the extent that collections exceed a pro rata portionof allocated cost from the pool.

·             *Latin America* — Equityin losses of Latin American Acquisition Partnerships were $.3 million in thefirst nine months of 2006 compared to $.3 million in 2005. These partnershipsreflected losses of $6.0 million in the first nine months of 2006 compared tolosses of $4.8 million in 2005. Although the revenues were higher compared tothe previous period, the partnerships recorded foreign exchange losses of $8.6million in the first nine months of 2006 compared to gains of $9.2 million in2005 (of which $.30 million losses and $.74 million gains are included inequity earnings, respectively).  Inaddition, provisions net of recoveries of allowance for loan losses of $.9million were recorded in the first nine months of 2006 compared to $6.6 millionfor the same period in 2005. Interest expense of $8.0 million and $8.1 millionwere recorded during the first nine months of 2006 and 2005, respectively.  This interest is owed to the investors ofthese partnerships, of which FirstCity recorded $.8 million in 2006 and $1.1million in 2005 as interest income. FirstCity eliminated substantially all ofits loans receivable from the Mexican acquisition partnerships as a result ofthe restructure of the Mexican Investment Platform during the third quarter of2006.

·             *Europe* — Equity inearnings of Acquisition Partnerships located in Europe was $3.0 million in thefirst nine months of 2006 compared to $2.6 million in 2005 primarily due tocollections related to portfolio assets acquired in the fourth quarter of2005.  During the first nine months of2006 and 2005, FirstCity also recorded $.8 million and $.7 million,respectively, in foreign currency transaction gains (included in otherexpenses) relating to investments in Europe.

*Gain on sale of equity investments.*  Gain onsale of equity investments was recorded in the first nine months of $2.4million. This gain primarily consisted of: 1) one domestic equity investmentresulting in a gain of $1.3 million and; 2) a partial sale of twelve LatinAmerican equity investments to AIG resulting in a gain of $1.1 million inaccordance with the restructuring of the Mexican Investment Platform.

### *Other ItemsAffecting Operations*

The following items affect the Company’s overall results of operationsand are not directly related to the Company’s Portfolio Asset acquisition andresolution business discussed above.

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*Corporate interest and overhead. *Corporate overheadexpenses decreased 10.3% to $3.8 million in the first nine months of 2006 from$4.2 million in the first nine months of 2005, primarily due to decreasedsalaries and legal and accounting fees.

*Income taxes. *Provision for incometaxes was $.14 million in the first nine months of 2006 compared to $.3 millionin the first nine months of 2005 and related primarily to state incometaxes.  Federal income taxes are provided at a 35% rate applied to taxable incomeor loss and are offset by NOLs that the Company believes are available. The taxbenefit of the NOLs is recorded in the period during which the benefit isrealized. The Company recorded no deferred tax provision in either of the firstnine months of 2006 or 2005.

*Discontinued Operations.*Discontinued operations include a net loss from mortgage operations of$75,000 in the first nine months of 2006 compared to $.3 million in the firstnine months of 2005. At September 30, 2006, the only asset remaining fromdiscontinued mortgage operations is an investment security resulting from theretention of a residual interest in a securitization transaction.

#### **FinancialCondition**

Major changes in FirstCity’s financial condition resulted from thefollowing:

Consolidated assets of $213.5 million at September 30, 2006, were $18.6million higher than that at December 31, 2005 primarily due to increases inPortfolio Assets offset by decreases in Loans Receivable. Portfolio Assetsincreased by $29.6 million as a result of acquisitions made during 2006.  Loans Receivable from Acquisition Partnershipsheld for investment decreased by $12.5 million primarily due to therestructuring of loans receivable from Mexican Acquisition Partnerships toequity investments.

Consolidated liabilities of $111.8 million as of September 30, 2006, were$15.9 million higher than that at December 31, 2005. Total notes payableincreased by $15.7 million and reflected advances of $106.6 million primarilyfor portfolio acquisitions, net of repayments of $91.9 million.

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

Aggregate acquisitions by the Company are as follows (in thousands):

|                            | ** ** | **Purchase** | ** ** | **FirstCity**  | ** ** |
|----------------------------|------------|--------------|------------|----------------|------------|
| ** **                 | ** ** | **Price**    | ** ** | **Investment** | ** ** |
| First nine  months of 2006 |       | $            | 159,073    |           | $          | 73,781 |   |
| 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         |       |
|                            |            |              |            |                |            |  |  |

 

Thefollowing table presents selected information regarding the revenues andexpenses of the Company’s Portfolio Asset acquisition and resolution business(in thousands):

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**Analysis ofSelected Revenues and ExpensesPortfolio Asset Acquisition and Resolution**
| ** **                                                    | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                    | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                    | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Portfolio  Assets and Loans Receivable:**                   |       |                             |       |                            |       |   |   |   |   |
| Average investment in Portfolio Assets and loans  receivable: |       |                             |       |                            |       |   |   |   |   |
| Domestic                                                      |       | $                                | 64,192     |                            | $          | 44,568 |   | $ | 56,172 |   | $ | 40,305 |   |
| Canada                                                        |       | 573                              |       | —                          |       | 229 |   | — |   |
| Latin America                                                 |       | 6,519                            |       | 17,766                          |       | 12,774 |   | 18,548 |   |
| Europe                                                        |       | 2,645                            |       | 509                             |       | 2,158 |   | 517 |   |
| Total                                                         |       | $                                | 73,929     |                            | $          | 62,843 |   | $ | 71,333 |   | $ | 59,370 |   |
| Income from Portfolio Assets and loans receivable:            |       |                             |       |                            |       |   |   |   |   |
| Domestic                                                      |       | $                                | 2,640      |                            | $          | 2,189 |   | $ | 7,797 |   | $ | 6,445 |   |
| Canada                                                        |       | 17                               |       | —                          |       | 17 |   | — |   |
| Latin America                                                 |       | 155                              |       | 349                             |       | 834 |   | 1,096 |   |
| Europe                                                        |       | 46                               |       | 7                               |       | 109 |   | 22 |   |
| Total                                                         |       | $                                | 2,858      |                            | $          | 2,545 |   | $ | 8,757 |   | $ | 7,563 |   |
| Average return (annualized):                                  |       |                             |       |                            |       |   |   |   |   |
| Domestic                                                      |       | 16.5                             | %          | 19.6                            | %          | 18.5 | % | 21.3 | % |
| Canada                                                        |       | 11.9                             | %          | n/a                             |       | 9.9 | % | n/a |   |
| Latin America                                                 |       | 9.5                              | %          | 7.9                             | %          | 8.7 | % | 7.9 | % |
| Europe                                                        |       | 7.0                              | %          | 5.5                             | %          | 6.7 | % | 5.7 | % |
| Total                                                         |       | 15.5                             | %          | 16.2                            | %          | 16.4 | % | 17.0 | % |
| **Servicing  fee revenues:**                                  |       |                             |       |                            |       |   |   |   |   |
| Domestic partnerships:                                        |       |                             |       |                            |       |   |   |   |   |
| Servicing fee revenue                                         |       | $                                | 825        |                            | $          | 751 |   | $ | 2,798 |   | $ | 2,725 |   |
| Average servicing fee %                                       |       | 3.0                              | %          | 3.8                             | %          | 2.9 | % | 3.8 | % |
| Latin American partnerships:                                  |       |                             |       |                            |       |   |   |   |   |
| Servicing fee revenue                                         |       | $                                | 1,883      |                            | $          | 2,039 |   | $ | 5,243 |   | $ | 5,935 |   |
| Average servicing fee %                                       |       | 6.6                              | %          | 13.8                            | %          | 9.1 | % | 12.1 | % |
| Incentive service fees                                        |       | $                                | 1,971      |                            | $          | 101 |   | $ | 2,141 |   | $ | 312 |   |
| Total Service Fees:                                           |       |                             |       |                            |       |   |   |   |   |
| Servicing fee revenue                                         |       | 4,679                            |       | 2,891                           |       | 10,182 |   | 8,972 |   |
| Average servicing fee %                                       |       | 8.3                              | %          | 8.4                             | %          | 6.7 | % | 7.4 | % |
| **Collections:**                                              |       |                             |       |                            |       |   |   |   |   |
| Domestic                                                      |       | $                                | 27,898     |                            | $          | 19,781 |   | $ | 95,007 |   | $ | 72,008 |   |
| Latin America                                                 |       | 28,325                           |       | 14,749                          |       | 57,529 |   | 48,924 |   |
| Europe                                                        |       | 11,049                           |       | 12,477                          |       | 40,164 |   | 41,463 |   |
| Subtotal                                                      |       | 67,272                           |       | 47,007                          |       | 192,700 |   | 162,395 |   |
| Wholly owned                                                  |       | 8,823                            |       | 5,804                           |       | 30,970 |   | 19,735 |   |
| Total                                                         |       | $                                | 76,095     |                            | $          | 52,811 |   | $ | 223,670 |   | $ | 182,130 |   |
| **Personnel:**                                                | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Personnel expenses                                            |       | $                                | 3,120      |                            | $          | 2,852 |   | $ | 8,557 |   | $ | 9,039 |   |
| Number of personnel (at period end):                          |       |                             |       |                            |       |   |   |   |   |
| Domestic                                                      |       | 58                               |       | 65                              |       |   |   |   |   |
| Latin America                                                 |       | 118                              |       | 137                             |       |   |   |   |   |
| Subtotal                                                      |       | 176                              |       | 202                             |       |   |   |   |   |
| Corporate                                                     |       | 32                               |       | 33                              |       |   |   |   |   |
| Total                                                         |       | 208                              |       | 235                             |       |   |   |   |   |
| **Interest  expense:**                                        |       |                             |       |                            |       |   |   |   |   |
| Average debt                                                  |       | $                                | 84,932     |                            | $          | 52,385 |   | $ | 87,020 |   | $ | 51,154 |   |
| Interest expense                                              |       | 1,799                            |       | 918                             |       | 5,455 |   | 2,646 |   |
| Average cost (annualized)                                     |       | 8.5                              | %          | 7.0                             | %          | 8.4 | % | 6.9 | % |
| **Provision  (recovery) for impairment on Portfolio Assets:** |       |                             |       |                            |       |   |   |   |   |
| Non-performing                                                |       | $                                | (8         | )                               | $          | — |   | $ | 9 |   | $ | — |   |
| Performing                                                    |       | (4                               | )          | 282                             |       | — |   | 396 |   |
| Real estate                                                   |       | 22                               |       | 18                              |       | 24 |   | 18 |   |
| Loans acquired after 2004 with credit deterioration           |       | 21                               |       | —                          |       | 29 |   | — |   |
| Loans acquired after 2004 with no credit  deterioration       |       | 19                               |       | 22                              |       | 39 |   | 22 |   |
|                                                          |       | $                                | 50         |                            | $          | 322 |   | $ | 101 |   | $ | 436 |   |

 

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The following table presents selected information regarding the revenuesand expenses of the Acquisition Partnerships (dollars in thousands):

**Analysis ofSelected Revenues and ExpensesAcquisition Partnerships**

|                                                 | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                      | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                      | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenues:                                       |       |                             |       |                            |       |   |   |   |   |
| Income from Portfolio Assets                    |       | $                                | 26,066     |                            | $          | 16,935 |   | $ | 64,572 |   | $ | 59,477 |   |
| Other income                                    |       | 336                              |       | 252                             |       | 1,884 |   | 621 |   |
| Interest  expense:                              |       |                             |       |                            |       |   |   |   |   |
| Interest expense                                |       | $                                | 4,931      |                            | $          | 3,559 |   | $ | 11,239 |   | $ | 11,736 |   |
| Average cost (annualized)                       |       | 8.17                             | %          | 4.68                            | %          | 5.78 | % | 4.90 | % |
| Other expenses:                                 |       |                             |       |                            |       |   |   |   |   |
| Service fees                                    |       | $                                | 5,486      |                            | $          | 5,416 |   | $ | 12,681 |   | 14,803 |   |
| Other operating costs                           |       | 7,914                            |       | 9,037                           |       | 17,154 |   | 21,752 |   |
| Foreign currency (gains) losses                 |       | (4,660                           | )          | (113                            | )          | 8,558 |   | (9,188 | ) |
| Income taxes                                    |       | 234                              |       | 269                             |       | 596 |   | 1,070 |   |
| Total other expenses                            |       | 8,974                            |       | 14,609                          |       | 38,989 |   | 28,437 |   |
| Net earnings (loss)                             |       | $                                | 12,497     |                            | $          | (981 | ) | $ | 16,228 |   | $ | 19,925 |   |
| Equity in  earnings of Acquisition Partnerships |       | $                                | 2,992      |                            | $          | 1,975 |   | $ | 7,811 |   | $ | 8,385 |   |
| Equity in  earnings of Servicing Entities       |       | 31                               |       | (192                            | )          | 233 |   | 489 |   |
| Equity in  earnings of investments              |       | $                                | 3,023      |                            | $          | 1,783 |   | $ | 8,044 |   | $ | 8,874 |   |

 

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

|                                                | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                     | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                     | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| **FirstCity’s  Average investment**       |       |                             |       |                            |       |   |   |   |   |
| Domestic                                       |       | $                                | 38,993     |                            | $          | 37,384 |   | $ | 47,792 |   | $ | 36,716 |   |
| Latin America                                  |       | 16,739                           |       | 1,598                           |       | 8,431 |   | 1,521 |   |
| Europe                                         |       | 18,635                           |       | 11,285                          |       | 19,123 |   | 12,052 |   |
| Europe-Servicing subsidiaries                  |       | 5,570                            |       | 5,537                           |       | 5,538 |   | 5,964 |   |
| Latin America-Servicing subsidiaries           |       | 162                              |       | 295                             |       | 205 |   | 204 |   |
| Total                                          |       | $                                | 80,099     |                            | $          | 56,099 |   | $ | 81,089 |   | $ | 56,457 |   |
|                                           |       |                             |       |                            |       |   |   |   |   |
| **FirstCity  share of equity earnings (loss)** |       |                             |       |                            |       |   |   |   |   |
| Domestic                                       |       | $                                | 1,282      |                            | $          | 1,784 |   | $ | 5,136 |   | $ | 6,008 |   |
| Latin America                                  |       | 815                              |       | (441                            | )          | (316 | ) | (250 | ) |
| Europe                                         |       | 895                              |       | 632                             |       | 2,991 |   | 2,627 |   |
| Europe-Servicing subsidiaries                  |       | 67                               |       | (155                            | )          | 433 |   | 247 |   |
| Latin America-Servicing subsidiaries           |       | (36                              | )          | (37                             | )          | (200 | ) | 242 |   |
| Total                                          |       | $                                | 3,023      |                            | $          | 1,783 |   | $ | 8,044 |   | $ | 8,874 |   |

 

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**Provisionfor Income Taxes**

The Company has substantial NOLs, which can be used to offset the taxliability associated with the Company’s pre-tax earnings until the earlier ofthe expiration or utilization of such NOLs. The Company accounts for thebenefit of the NOLs by recording the benefit as an asset and then establishinga valuation allowance to value the net deferred tax asset at a level, whichmore likely than not, will be realized. Realization is determined based onmanagement’s expectation of generating sufficient taxable income in a lookforward period over the next four years. The ultimate realization of theresulting net deferred tax asset is dependent upon generating sufficienttaxable income from its continuing operations prior to expiration of the NOLs.Although realization is not assured, management believes it is more likely thannot that all of the recorded deferred tax asset, net of the allowance, will berealized. The amount of the deferred tax asset considered realizable, however,could be adjusted in the future if estimates of future taxable income duringthe carryforward period change. The ability of the Company to realize thedeferred tax asset is periodically reviewed and the valuation allowance isadjusted accordingly.

**Liquidityand Capital Resources**

Generally, the Company requires liquidity to fund itsoperations, working capital, payment of debt, repurchase of the Company’scommon stock**,** 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.

As of September 30, 2006, FirstCity had a $91 millionrevolving acquisition facility with Bank of Scotland that matures in November2008.  This facility is used to financethe equity portion of distressed asset pool purchases and to provide for theissuance of Letters of Credit and working capital loans.  This facility (i) allows loans to be made inEuros up to a maximum amount in Euros that is equivalent to 35 million U.S.dollars, (ii) allows loans to be made for acquisition of Portfolio Assetsoriginated in Latin America of up to $35 million, (iii) provides for an interestrate of LIBOR plus 2.50% to 2.75%, (iv) provides for an annual commitment feeof 0.20% of the average daily unused balance of the revolving acquisitionfacility, (v) provides that the aggregate borrowings under the facility doesnot exceed 60% of the net present value of FirstCity’s interest in PortfolioAssets and in Acquisition Partnerships pledged to secure the acquisitionfacility, and (vi) provides for a reduction in the total loan commitment of$1.3 million per quarter, commencing on December 27, 2005.

On November 1, 2006, FirstCity and Bank of Scotland,as agent for the lenders, entered into an Amendment No. 4 to Revolving CreditAgreement, dated as of October 31, 2006 (the “Amendment”).  The Amendmentamended the existing $96,000,000 revolving credit facility entered into onNovember 12, 2004, to increase the revolving credit facility to $175,000,000that matures on November 12, 2010.  The Amendment made the followingchanges to the existing loan facility that is used to finance the senior debt andequity portion of portfolio and asset purchases made by FirstCity and toprovide for the issuance of letters of credit and working capital loans: (i)increased the maximum outstanding amount of loans and letters of credit issuedunder the loan facility that may be outstanding under the loan facility to$175,000,000; (ii) reduced the available interest rates under the loan facilityby 0.5% per annum; (iii) increased the maximum value for assets that can beincluded in the borrowing base from the acquisition of portfolio assets incertain countries as follows (a) Mexico increased to $30,000,000, (b) Brazilincreased to $5,000,000, (c) Chile to $10,000,000, and (d) Argentina or Uruguayto $6,000,000; (iv) increased the limit for Loans that can be borrowed in Eurosunder the loan facility to $50,000,000; (v) increased the maximum amount ofletters of credit that can be issued under the loan facility to $40,000,000;(vi) increased the maximum amount of working capital loans that can beoutstanding under the loan facility to $35,000,000; (vii) provided for anadditional upfront fee paid to Bank of Scotland in the amount of $830,000;(viii) amended the requirement for the ratio of EBITDA to Interest Coverage tobe not less than 1.50 to 1.00 for each twelve month period, and added a newcovenant that FirstCity must maintain a ratio of Cumulative Current Recoveredand Projected Collections to Cumulative Original Projected Collections of notless than 0.90 to 1.00; and (ix) extended the maturity date for the loan facilityto November 12, 2010.  The obligations of FirstCity under the RevolvingCredit Agreement are guaranteed by substantially all of the wholly-ownedsubsidiaries of FirstCity and are secured by security interests insubstantially all of the assets of FirstCity and its wholly-owned subsidiaries.

InAugust 2005, FH Partners, L.P., an indirect wholly-owned affiliate ofFirstCity, and Bank of Scotland, acting through its New York branch, as agentfor itself as lender, entered into a Revolving Credit Agreement that providesfor a $50 million revolving Portfolio acquisition facility for FH Partners,L.P. to be secured by all of the assets of FH Partners, L.P.  The loan facility will be used to financePortfolio and asset purchases.  Thefacility (i) allows loans to be made for the acquisition of PortfolioAssets in the United

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States, (ii) provides that each loan may be in anamount of up to 70% of the net present value of the assets being acquired withthe proceeds of the loan, (iii) provides that the aggregate outstandingbalances of all loans will not exceed 65% of the net present value of theassets securing the loan facility, (iv) provides for an interest rate ofLIBOR plus 2.0%, (v) provides for an annual commitment fee of 0.20% of theaverage daily unused balance of the revolving acquisition facility,(vi) provides for a utilization fee of 0.75% of the amount of each loanmade under the loan facility, (vii) provides for an upfront fee of$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, $75,000, for the period commencing on the firstanniversary of the Effective Date and ending the day before the secondanniversary thereof, and $50,000, for each subsequent one-year period, and (ix)provides for a maturity date of November 12, 2008.  The obligations of FH Partners, L.P. underthe Revolving Credit Agreement are guaranteed by FirstCity and the primarywholly-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 will expire on August 31, 2010,if it is not exercised prior to that date.

Excluding the term acquisition facilities of theunconsolidated Acquisition Partnerships, the Company and its subsidiariescurrently have credit facilities providing for borrowings in an aggregateprincipal amount of $239 million, and outstanding borrowings of $106 million asof September 30, 2006.

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 November 9, 2006, andthe outstanding borrowings under such facilities as of September 30, 2006.

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**Credit Facilities**
| ** **                                                                            | ** ** | **Funded and**                 | ** ** | ** **             | ** ** | ** **                                                        | ** ** | ** **                                                                                       | ** ** |
|---------------------------------------------------------------------------------------|------------|-------------------------------------|------------|------------------------|------------|-------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------|------------|
| ** **                                                                            | ** ** | **Unfunded**                        | ** ** | **Outstanding**        | ** ** | ** **                                                        | ** ** | ** **                                                                                       | ** ** |
| ** **                                                                            | ** ** | **Commitment**                      | ** ** | **Borrowings**         | ** ** | ** **                                                        | ** ** | ** **                                                                                       | ** ** |
| ** **                                                                            | ** ** | **Amount as of**          | ** ** | **as of**         | ** ** | ** **                                                        | ** ** | ** **                                                                                       | ** ** |
| ** **                                                                            | ** ** | **November 9,**                | ** ** | **September 30,** | ** ** | ** **                                                        | ** ** | ** **                                                                                       | ** ** |
| ** **                                                                            | ** ** | **2006**                            | ** ** | **2006**               | ** ** | **Interest Rate**                                            | ** ** | **Other Terms and Conditions**                                                    | ** ** |
| ** **                                                                            | ** ** | **(Dollars in millions)** | ** ** | ** **             | ** ** | ** **                                                        | ** ** |
| Bank of Scotland  $175 million portfolio acquisition and working capital facility (1) |       | $                                   | 175        |                   | $          | 62                                                                |       | LIBOR  + 2.0% - 2.25%                                                                            |       | Secured  by equity interests  and other assets of FirstCity,  matures November 2010 |   |
|                                                                                  |       |                                |       |                   |       |                                                              |       |                                                                                             |       |
| Bank of Scotland  $50 million portfolio acquisition - revolving credit                |       | 50                                  |       | 33                     |       | 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                |       |
|                                                                                  |       |                                |       |                   |       |                                                              |       |                                                                                             |       |
| Participation  payable                                                                |       | 1                                   |       | 1                      |       | 32.36%  imputed rate                                              |       | Participation  agreement  on 33% of net cash flows  received on one portfolio                    |       |
|                                                                                  |       |                                |       |                   |       |                                                              |       |                                                                                             |       |
| CorpBanca  revolving line of credit for Chilean portfolio acquisition                 |       | 10                                  |       | 7                      |       | Rate  based on monthly  Chilean index rate plus  .0625% per month |       | Secured  by Bank of Scotland  letter of credit.  Renewable every 30 days.                        |       |
|                                                                                  |       |                                |       |                   |       |                                                              |       |                                                                                             |       |
| Total                                                                                 |       | $                                   | 239        |                   | $          | 106                                                               |       |                                                                                             |       |   |   |
|                                                                                  |       |                                |       |                   |       |                                                              |       |                                                                                             |       |
| Unconsolidated  Acquisition Partnerships Term Facilities (2)                          |       | $                                   | 69         |                   | $          | 69                                                                |       | Various rates                                                                                    |       | Secured by Portfolio  Assets, various maturities  non-recourse |   |

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(1)          The Bank of Scotlandfacility allows loans to be made in Euros up to a maximum amount in Euros thatis equivalent to $50 million.  AtSeptember 30, 2006, the Company had approximately $16.0 million outstandingunder the Euro-denominated portion of this facility.

(2)          In addition to the termacquisition facilities of the unconsolidated Acquisition Partnerships, theLatin American Acquisition Partnerships also have term debt of approximately$112.1 million outstanding as of September 30, 2006, owed to affiliates of theinvestor groups. Of this amount, the Company has recorded approximately $1.4million as Loans Receivable on the Consolidated Balance Sheets.

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**Forward-LookingStatements**

Certainstatements contained in this Quarterly Report on Form 10-Q or incorporated byreference from time to time, including, but not limited to, statements relatingto the Company’s strategic objectives and future performance, which are nothistorical facts, may be deemed to be forward-looking statements under thePrivate Securities Litigation Reform Act of 1995. Forward-looking statementsinclude, without limitation, any statement that may project, indicate or implyfuture results, performance or achievements, and may contain the words “expect,”“intend,” “plan,” “estimate,” “believe,” “will be,” “will continue,” “willlikely result,” and similar expressions. Such statements inherently are subjectto a variety of risks and uncertainties that could cause actual results todiffer materially from those projected. There are many important factors thatcould cause the Company’s actual results to differ materially from thoseindicated in the forward-looking statements. Such factors include, but are notlimited to, risks associated with foreign operations; currency exchange ratefluctuations; the performance of the Company’s subsidiaries and affiliates; theavailability of Portfolio Assets; assumptions underlying Portfolio assetperformance; interest rate risk; the degree to which the Company is leveraged;the Company’s continued need for financing; availability of the Company’scredit facilities; the impact of certain covenants in loan agreements of theCompany and its subsidiaries; risks of declining value of loans, collateral orassets; the ability of the Company to utilize NOLs; uncertainties of anylitigation that might arise from discontinued operations; general economicconditions; foreign social and economic conditions; changes (legislative andotherwise) in the asset securitization industry; fluctuations in residentialand commercial real estate values; capital market conditions, including themarkets for asset-backed securities; factors more fully discussed andidentified in the Company’s Annual Report on Form 10-K, for the year endedDecember 31, 2005, filed with the Securities and Exchange Commission on March16, 2006 (including those discussed under “Item 7. Management’s Discussion andAnalysis of Financial Condition and Results of Operations”), as well as inother Securities 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 Form10-Q speak 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 andQualitative 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). InEurope, the Company’s investments are in the form of equity and represent asignificant portion of the Company’s total equity investments. As of September30, 2006, one U.S. dollar equaled .79 Euros. A sharp change in the Eurorelative to the U.S. dollar could materially adversely affect the financialposition and results of operations of the Company. A 5% and 10% incrementaldepreciation of the Euro would result in an estimated decline in the valuationof the Company’s equity investments in Europe of approximately $1.3 million and$2.5 million, respectively. These amounts are estimates of the financial impactof a depreciation 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

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Company’s consolidated financial position or resultsof operations. As discussed above, the revolving acquisition facility with Bankof Scotland was increased to a maximum of $175 million and allows loans to bemade in Euros up to a maximum amount in Euros that is equivalent to $50 millionU.S. dollars. At September 30, 2006, the Company held $16.0 million in Euro-denominateddebt for the purpose of hedging a portion of the net equity investments inEurope. Management of the Company feels that this loan agreement will helpreduce the risk of adverse effects of currency changes on Euro-denominatedinvestments.

FirstCity converted substantially all of its loansreceivable from Mexican acquisition partnerships to equity investments as aresult of the restructure of investments in Mexico during the third quarter of2006.  The future estimated cash flows ofthe underlying assets in Mexico could become less valuable as a result of achange in the exchange rate for the Mexican peso, and thus, could affect theoverall total returns to the Company on these investments. As of September 30,2006, one U.S. dollar equaled 11.02 Mexican pesos. A 5% and 10% incrementaldepreciation of the Mexican peso would result in an estimated decline in thevaluation of the Company’s total investments in Mexico of approximately $2.5million and $4.8 million, respectively. These amounts are estimates of thefinancial impact of a depreciation of the Mexican peso relative to the U.S.dollar. Consequently, these amounts are not necessarily indicative of theactual effect of such changes with respect to the Company’s consolidatedfinancial position or results of operations.

FirstCity has loans and equity investments in SouthAmerica — primarily in Argentina Acquisition Partnerships. As of September 30,2006, one U.S. dollar equaled 3.11 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 $.11 million and $.20 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 September 30, 2006, one U.S. dollarequaled 34.74 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.**

An evaluation was performed under the supervision and with theparticipation of the Company’s management, including the Company’s ChiefExecutive Officer and Chief Financial Officer, of the effectiveness of thedesign and operation of the Company’s disclosure controls and procedures (asdefined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of1934) as of September 30, 2006.  Based onthat evaluation, the Chief Executive Officer and Chief Financial Officerconcluded that the Company’s disclosure controls and procedures were effective,in all material respects, to ensure that information required to be disclosedin the reports the Company files and submits under the Exchange Act isrecorded, processed, summarized and reported as and when required.  The Company’s management, including theCompany’s Chief Executive Officer and Chief Financial Officer, also evaluatedwhether any change in the Company’s internal controls over financial reportingor in other factors had occurred during the fiscal quarter covered by thisreport.  Based upon that evaluation,management concluded that there had been no such changes during the periodcovered by this report that have materially affected, or is reasonably likelyto affect, the registrant’s internal control over financial reporting.

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**PART II**

**OTHER INFORMATION**

**Item 1.  Legal Proceedings.**

Periodically, FirstCity, its subsidiaries, itsaffiliates and the Acquisition Partnerships are parties to or otherwise involvedin legal proceedings arising in the normal course of business. FirstCity doesnot believe that there is any proceeding threatened or pending against it, itssubsidiaries, 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.

On January 19,2005, Prudential Financial, Inc. (“Prudential”) filed a petition ininterpleader seeking to interplead 321,211 shares of Prudential common stockand any associated dividends arising from the demutualization of Prudential inDecember 2000. The shares of Prudential common stock related to group annuitycontracts purchased by First-City National Bank of Houston, as trustee of theFirst City Bancorporation Employee Retirement Trust (the “Trust”) to fundobligations to participants in the First City Bancorporation EmployeeRetirement Plan (the “Plan”) in connection with termination of the Plan and theTrust in 1987. FirstCity, FCLT Loans Asset Corp. (“FCLT”), an alleged assigneeof the FirstCity Liquidating Trust, JP Morgan Chase Bank, National Association(“JP Morgan”), and First-City National Bank of Houston as trustee of the Trustwere made defendants in the suit as claimants to the Prudential common stockand dividends. An agreed order dated January 27, 2005, was entered by the Courtproviding that the Prudential common stock be transferred to JP Morgan as recordowner and that JP Morgan sell the stock. The January 27, 2005 order alsoprovided 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 onJanuary 28, 2005 for total proceeds of approximately $17.5 million. JP Morganalso received funds in the amount of approximately $489,000, which weredividend payments related to the Prudential common stock.  The proceeds are being held by JP Morganpending resolution of the conflicting claims. According to JP Morgan’s report dated as of the close of business June30, 2006, the demutualization proceeds held by JP Morgan totaled approximately$18 million.  JP Morgan filed a thirdparty action naming Mr. Blair as a third party defendant with an allegedinterest in the demutualization proceeds. On October 1, 2005, the court certified a class represented by Mr.Blair.  FCLT made claims againstFirstCity for alleged breach of contract by FirstCity in claiming thedemutualization proceeds and alleged tortious interference by FirstCity withFCLT’s alleged right to the demutualization proceeds.

FirstCity, FCLTand Mr. Blair each filed motions for summary judgment asserting ownership ofthe proceeds of the common stock and the dividends and accrued income.  On March 21, 2006, FirstCity received noticethat the 152nd District Court, Harris County, Texas granted FirstCity’s motionfor partial summary judgment.  The ordergranting FirstCity’s motion for partial summary judgment rendered judgment infavor of FirstCity as to the ownership of the demutualization proceeds.  The Court’s summary judgment order alsodenied the claims to ownership of the demutualization proceeds by FCLT and Mr.Blair, individually and as representative of the proposed class of employeebeneficiaries.  The motions submitted tothe Court prior to its order dated March 21, 2006 did not address all matterspending in the lawsuit.  Mr. Blair, asclass representative, filed a motion for new trial to set aside the summaryjudgment in favor of FirstCity and for reconsideration of granting Mr. Blair’smotion for summary judgment.  FCLT fileda motion for the Court to reconsider its order granting the partial summary judgmentfor FirstCity.  FirstCity moved forsummary judgment on all remaining claims and for entry of a final judgment onMay 12, 2006.  On August 14, 2006, theCourt entered an order (i) finding that FirstCity is the sole owner of the “demutualizationproceeds” consisting of the proceeds from the sale of the 321,211 shares ofPrudential Financial, Inc. stock, the dividends on such shares and all accruedinterest and income arising there from, (2) granting FirstCity’s motion forsummary judgment against FCLT’s claims for breach of contract and tortiousinterference, (3) providing that JP Morgan continue to hold the demutualizationproceeds until the appellate process has been completed, (4) denying therequest by FirstCity that FCLT or Mr. Blair be required to post bond or otherform of security on appeal, and (5) denying all other claims for relief.  FCLT and Mr. Blair have filed notices ofappeal to the First or Fourteenth Court of Appeals of the State of Texas.  FirstCity cannot give any assurances as to thetime period for the appeal of the final judgment or the timing of receipt orultimate amount of proceeds to be received, if any.

**Item 1A.  Risk Factors.**

Therehave been no material changes to the risk factors as previously disclosed underItem 1A in the Company’s Annual Report on Form 10-K for the year ended December31, 2005.

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

The following summarizes purchases of common stock during the thirdquarter 2006:

|            | ** ** | ** **            | ** ** | ** **          | ** **   | **Total Number**                  | ** ** | **Maximum Number**               | ** ** |
|------------|------------|-----------------------|------------|---------------------|--------------|----------------------------------------|------------|---------------------------------------|------------|
| ** ** | ** ** | ** **            | ** ** | ** **          | ** **   | **of Shares Purchased**      | ** ** | **of Shares that May** | ** ** |
| ** ** | ** ** | **Total Number** | ** ** | **Average**         | ** **   | **as Part of Publicly** | ** ** | **Yet Be Purchased**        | ** ** |
| ** ** | ** ** | **of Shares**    | ** ** | **Price Paid** | ** **   | **Announced Plans**               | ** ** | **Under the Plans**         | ** ** |
| **Month**  | ** ** | **Purchased**         | ** ** | **Per Share**  | *** *** | **or Programs (1)**          | ** ** | **or Programs**                  | ** ** |
| August     |       | 480,000               |       | $                   | 10.51        |                                   | 480,000    |                                  |       |   |
| September  |       | 50,300                |       | $                   | 10.47        |                                   | 50,300     |                                  |       |   |
| Total      |       | 530,300               |       | $                   | 10.51        |                                   | 530,300    |                                  | 469,700    |   |

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(1)  The Company has a repurchaseprogram approved by the Board of Directors in August 2006 for the repurchase ofup to 1,000,000 shares of the Company’s common stock over a period of twelvemonths.

**Item 3.  Defaults Upon SeniorSecurities.**

None

**Item 4.  Submission of Matters to a Vote of Security Holders.**

The Company held its annual meeting of stockholders(the “Annual Meeting”) on August 3, 2006. The following items for business wereconsidered at the Annual Meeting.

**(a) Election of Directors**

The following were elected as directors to serve asmembers of the Company’s Board of Directors until the Company’s 2007 annualmeeting of stockholders. The number of votes cast for each nominee was asfollows:

| Nominee                | ** ** | **Votes For** | ** ** | **Votes  Against** | ** ** | **Abstained** | ** ** |
|------------------------|------------|--------------------|------------|--------------------|------------|---------------|------------|
| Richard E. Bean        |       | 10,639,707         |       | 57,713             |       | —        |       |
| C. Ivan Wilson         |       | 10,118,223         |       | 579,197            |       | —        |       |
| James T. Sartain       |       | 10,639,793         |       | 57,627             |       | —        |       |
| Dane Fulmer            |       | 10,639,697         |       | 57,723             |       | —        |       |
| Robert E.  Garrison II |       | 10,639,707         |       | 57,713             |       | —        |       |
| D. Michael  Hunter     |       | 10,639,793         |       | 57,627             |       | —        |       |
| Jeffery D. Leu         |       | 10,638,707         |       | 58,713             |       | —        |       |
| F. Clayton Miller      |       | 10,639,591         |       | 57,829             |       | —        |       |

 

**(b) Approval of the Company’s 2006Stock Option and Award Plan**

The stockholdersapproved the Company’s 2006 Stock Option and Award Plan.  The number of votes for the proposal:8,048,274; votes against: 233,160; abstentions: 100,137.

**(c) Ratification of Appointment ofAuditors**

A proposal toratify the Board of Directors’ appointment of KPMG LLP as the Company’sindependent auditors for 2006 was approved by the stockholders. The number ofvotes for the proposal: 10,690,387; votes against: 3,350; abstentions: 3,683.

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**Item 5.  Other Information.**

On August 11, 2006, the Compensation Committee of theBoard of Directors of the Company approved a bonus of $50,000.00 be paid toRichard J. Vander Woude.

On August 3, 2006, the shareholders of the Companyapproved the FirstCity Financial Corporation 2006 Stock Option and Award Plan(the “Plan”) at the Company’s 2006 annual meeting of shareholders. The Plan wasadopted by the Company’s Board of Directors on August 3, 2006.

The Plan permits the grant of awards to employees ofthe Company and its subsidiaries and awards to non-employee directors of theCompany. Awards under the Plan may be made in the form of nonqualified stockoptions, incentive stock options, performance shares and restricted stock. Atotal of 500,000 shares of common stock are authorized for issuance pursuant tothe Plan. Additional shares subject to outstanding awards granted under otherstock incentive plans of the Company may become available for issuance pursuantto the Plan if the awards are terminated without issuance of the shares,settled for cash, or exchanged for non-share awards.

The Plan will be administered by the Company’sCompensation Committee, and will terminate on the day prior to the tenthanniversary of its effective date of August 3, 2006, unless terminated earlierin specified circumstances.

A detailed description of the terms of the Plan is setforth in the Company’s definitive proxy statement for the 2006 annual meetingof shareholders, which was filed with the Securities and Exchange Commission onJune 26, 2006. A copy of the Plan is incorporated by reference to exhibit 10.13to this Report.

**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).                                                                                                                                                                                                            |       |

 

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| 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 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)                                 |   |
|   |       |       |   |                                                                                                                                                                                                                                                                                                                                                                                 |   |
| 10.13  |       | —     |   | 2006 Stock Option and Award Plan (incorporated  herein by reference to Appendix A of the Company’s Schedule 14A, Definitive  Proxy Statement, dated June 26, 2006)                                                                                                                                                                                                              |   |
|   |       |       |   |                                                                                                                                                                                                                                                                                                                                                                                 |   |
| 10.14* | ** ** | **—** |   | Interest Purchase and Sale Agreement, dated August  8, 2006, by and among Bidmex Holding, LLC, and Strategic Mexican Investment  Partners, L.P. and Cargill Financial Services International, Inc. and certain  other parties                                                                                                                                                        |   |
|   |       |       |   |                                                                                                                                                                                                                                                                                                                                                                                 |   |
| 10.15* | ** ** | **—** |   | Put Option Agreement dated August 8, 2006, by and  among Bidmex Holding, LLC, Recuperacion de Carteras Mexicanas, S. de R.L. de  C.V., Bidmex 6, LLC, Strategic Mexican Investment Partners 2, L.P. and Cargill  Financial Services International, Inc.                                                                                                                              |   |
|   |       |       |   |                                                                                                                                                                                                                                                                                                                                                                                 |   |
| 10.16* | ** ** | **—** |   | Guarantee dated August 8, 2006, executed by  FirstCity Financial Corporation for the benefit of Bidmex Holding, LLC,  Residencial Oeste 2 S. de R.L. de C.V., National Union Fire Insurance Company  of Pittsburg, P.A., American General Life Insurance Company, and American  General Life and Accident Insurance Company                                                          |   |
|   |       |       |   |                                                                                                                                                                                                                                                                                                                                                                                 |   |
| 10.17  |       | —     |   | Amendment No. 4 to Revolving Credit Agreement, dated  as of October 31, 2006, 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 10.1 of the Company’s Form 8-K  dated November 7, 2006)                                                                |   |

 

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Table of Contents

 
| 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 September 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  September 30, 2006.  |   |

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*           Filed herewith.

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Table of Contents

**SIGNATURES**

Pursuant to the requirements of the Securities Exchange Act of 1934, theregistrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly 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: November 9, 2006 |                             |   |

 

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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)                                                                                                                                                                           |       |

 

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Table of Contents

 
| 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) |   |
| 10.13  |       | —     |   | 2006 Stock Option and Award Plan (incorporated  herein by reference to Appendix A of the Company’s Schedule 14A, Definitive  Proxy Statement, dated June 26, 2006)                                                                                                                                                                              |   |
|   |       |       |   |                                                                                                                                                                                                                                                                                                                                                 |   |
| 10.14* | ** ** | **—** |   | Interest Purchase and Sale Agreement, dated August  8, 2006, by and among Bidmex Holding, LLC, and Strategic Mexican Investment  Partners, L.P. and Cargill Financial Services International, Inc. and certain  other parties                                                                                                                        |   |
|   |       |       |   |                                                                                                                                                                                                                                                                                                                                                 |   |
| 10.15* | ** ** | **—** |   | Put Option Agreement dated August 8, 2006, by and  among Bidmex Holding, LLC, Recuperacion de Carteras Mexicanas, S. de R.L. de  C.V., Bidmex 6, LLC, Strategic Mexican Investment Partners 2, L.P. and  Cargill Financial Services International, Inc.                                                                                              |   |
|   |       |       |   |                                                                                                                                                                                                                                                                                                                                                 |   |
| 10.16* | ** ** | **—** |   | Guarantee dated August 8, 2006, executed by  FirstCity Financial Corporation for the benefit of Bidmex Holding, LLC,  Residencial Oeste 2 S. de R.L. de C.V., National Union Fire Insurance Company  of Pittsburg, P.A., American General Life Insurance Company, and American  General Life and Accident Insurance Company                          |   |
|   |       |       |   |                                                                                                                                                                                                                                                                                                                                                 |   |
| 10.17  |       | —     |   | Amendment No. 4 to Revolving Credit Agreement, dated  as of October 31, 2006, 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 10.1 of the Company’s Form 8-K  dated November 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 September 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  September 30, 2006.                                                                      |   |
|        |            |            |        |                                                                                                                                                                                                                                                                                                                                                      |        |  |  |

 

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