U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

      For the fiscal year ended December 31, 2002

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

      For the transition period from _________________________ to _____________

Commission File Number: 0-30753

FIRST FEDERAL BANCSHARES, INC.
(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (309) 776-3225

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, par value $0.01 per share
(Title of Class)

        Indicated by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for 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 _____

        Indicated by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. __X__

        Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).
Yes _____ No __X__

         The aggregate market value of the voting and non-voting common equity held by non-affiliates was $30,842,794 based upon the closing price ($18.20 per share) as quoted on the Nasdaq National Market on June 28, 2002. Solely for purposes of this calculation, the shares held by the directors and officers of the registrant are deemed to be held by affiliates.

        The number of shares outstanding of the registrant’s common stock as of March 10, 2003 was 2,061,943.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the 2002 Annual Report to Stockholders and of the Proxy Statement for the 2003 Annual Meeting
of Stockholders are incorporated by reference in Parts II and III, respectively, of this Form 10-K.

INDEX          

        This report contains certain “forward-looking statements” within the meaning of the federal securities laws. These statements are not historical facts, rather statements based on First Federal Bancshares, Inc.’s current expectations regarding its business strategies, intended results and future performance. Forward-looking statements are preceded by terms such as “expects,” “believes,” “anticipates,” “intends” and similar expressions.

        Management’s ability to predict results or the effect of future plans or strategies is inherently uncertain. Factors which could affect actual results include interest rate trends, the general economic climate in the market area in which First Federal Bancshares operates, as well as nationwide, First Federal Bancshare’s ability to control costs and expenses, competitive products and pricing, loan delinquency rates and changes in federal and state legislation and regulation. These factors should be considered in evaluating the forward-looking statements and undue reliance should not be placed on such statements. First Federal Bancshares assumes no obligation to update any forward-looking statements.

PART I

Item 1. BUSINESS

General

        First Federal Bancshares, Inc., (also referred to as the “Company” or “First Federal Bancshares”) was organized as a Delaware business corporation in 2000 to be the savings and loan holding company for First Federal Bank (also referred to as the “Bank” or “First Federal”) in connection with the conversion of First Federal from mutual to stock form of ownership. The conversion was completed on September 27, 2000. First Federal Bancshares has no significant assets, other than all of the outstanding shares of First Federal, and no significant liabilities. Accordingly, the information set forth in this report, including the consolidated financial statements and related financial data, relates primarily to First Federal.

        First Federal operates as a community-oriented financial institution, specializing in the acceptance of retail deposits from the general public in the areas surrounding its nine full-service banking offices and using those funds, together with funds generated from operations and borrowings, to originate loans. The principal lending activity of First Federal is the origination of mortgage loans for the purpose of purchasing or refinancing one- to four-family residential property. First Federal also originates multi-family and commercial real estate loans, residential construction loans, commercial business loans and a variety of consumer loans. First Federal originates loans primarily for long-term investment purposes. First Federal also invests in mortgage-backed securities, securities issued by the U.S. Government and state and local governments, and other permissible investments. First Federal’s revenues are derived principally from the generation of interest and fees on loans originated and, to a lesser extent, interest and dividends on investments. First Federal’s primary sources of funds are deposits, principal and interest payments on loans and investments and advances from the Federal Home Loan Bank of Chicago.

Acquisitions

        On November 22, 2002, the Company completed the acquisition of PFSB Bancorp, Inc. (“PFSB”), and its wholly-owned subsidiary Palmyra Savings pursuant to an Agreement and Plan of Merger dated as of June 4, 2002, by and between the Company and PFSB. The acquisition was completed through the merger of PFSB with and into the Company. As part of the acquisition, Palmyra Savings merged with and into First Federal with First Federal being the surviving bank. First Federal Bancshares paid approximately $4.4 million in cash and issued approximately 252,000 shares of the Company’s common stock to the former stockholders of PFSB. The PFSB acquisition included total assets of approximately $73.8 and three banking offices in northeast Missouri.

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Market Area

        First Federal conducts business from six banking offices in west central Illinois and three banking offices in northeast Missouri. First Federal’s primary deposit gathering and lending area is concentrated in the communities surrounding its nine banking offices and, to a lesser extent, in the surrounding counties.

        The market area served by First Federal is generally rural and has an agriculturally-based economy. Adams County, Illinois, which is home to the city of Quincy, is a regional population and employment center for west central Illinois and northeast Missouri. Quincy has a diverse employment base and serves as a center for education, healthcare and related services.

Competition

        First Federal faces intense competition for the attraction of deposits and origination of loans in its market area. Its most direct competition for deposits has historically come from the several financial institutions operating in First Federal’s market area and, to a lesser extent, from other financial service companies, such as brokerage firms, credit unions and insurance companies. While those entities still provide a significant source of competition for deposits, First Federal also currently faces significant competition for deposits from the mutual fund industry as customers seek alternative sources of investment for their funds. In this regard, First Federal also faces competition for investors’ funds from their direct purchase of short-term money market securities and other corporate and government securities. First Federal’s competition for loans comes primarily from financial institutions in its market area, and to a lesser extent from other financial service providers, such as mortgage companies and mortgage brokers. Additionally, competition for loans has increased due to the increasing number of non-depository financial service companies entering the mortgage market, such as insurance companies, securities companies and specialty finance companies. First Federal expects competition to increase in the future as a result of legislative, regulatory and technological changes and the continuing trend of consolidation in the financial services industry. Technological advances, for example, have lowered barriers to entry, allowed banks to expand their geographic reach by providing services over the Internet and made it possible for non-depository institutions to offer products and services that traditionally have been provided by banks. The Gramm-Leach-Bliley Act, which permits affiliation among banks, securities firms and insurance companies, also promotes a competitive environment in the financial services industry. Some of the institutions with which First Federal competes are significantly larger than First Federal and, therefore, have significantly greater resources. Competition for deposits and the origination of loans could limit First Federal’s growth in the future.

Lending Activities

    General.        First Federal’s loan portfolio primarily consists of one- to four-family mortgage loans. To a lesser degree, First Federal’s loan portfolio also includes multi-family and commercial real estate loans, residential construction loans, commercial business loans and a variety of consumer loans. Most of First Federal’s borrowers are located in the counties where its branches are located and in the surrounding counties.

        First Federal’s loans are subject to federal laws and regulations. Interest rates charged by First Federal on loans are affected principally by First Federal’s current asset/liability strategy, the demand for various types of loans, the supply of money available for lending purposes and the rates offered by competitors. These factors are, in turn, affected by general and economic conditions, monetary policies of the federal government, including the Federal Reserve Board, legislative tax policies and governmental budgetary matters.

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        Loan Portfolio Analysis. The following table presents the composition of First Federal’s loan portfolio at the dates indicated. First Federal had no concentration of loans exceeding 10% of total loans receivable other than as disclosed below.

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        The following table presents certain information at December 31, 2002 regarding the dollar amount of loans maturing in First Federal’s portfolio based on their contractual terms to maturity or scheduled amortization, but does not include potential prepayments. Demand loans, loans having no stated schedule of repayments and no stated maturity, and overdrafts are reported as becoming due in one year or less. Loan balances do not include undisbursed loan proceeds, net deferred loan origination costs and allowance for loan losses. Construction loans are originated as construction/permanent. Therefore, some construction loans may have a term of longer then one year.

        Scheduled contractual principal repayments of loans do not reflect the actual life of the loans. The average life of a loan is substantially less than its contractual term because of prepayments. In addition, due-on-sale clauses on loans generally give First Federal the right to declare loans immediately due and payable if, among other things, the borrower sells the real property with the mortgage and the loan is not repaid. The average life of a mortgage loan tends to increase, however, when current mortgage loan market rates are substantially higher than rates on existing mortgage loans and, conversely, tends to decrease when rates on existing mortgage loans are substantially higher than current mortgage loan market rates.

        The following table presents the dollar amount of all loans due after December 31, 2003, which have fixed interest rates and floating or adjustable interest rates.

        One- to Four-Family Real Estate Loans. Prior to 2002, First Federal’s residential mortgage loans were primarily structured as either one-year adjustable-rate mortgage loans or five-year balloon loans. In 2002, First Federal discontinued offering five-year balloon loans and began offering adjustable-rate mortgage loans that adjust annually after a five year initial fixed period. The loan fees charged, interest rates and other provisions of First Federal’s mortgage loans are determined by First Federal on the basis of its own pricing criteria and market conditions.

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        First Federal’s adjustable-rate mortgage loans are based on an amortization schedule that ranges from 10 to 30 years. Interest rates and payments on First Federal’s adjustable-rate mortgage loans generally are adjusted annually after the initial term based on the Federal Housing Finance Board’s national average mortgage contract rate for major lenders on the purchase of previously occupied homes. The maximum amount by which the interest rate may be increased or decreased on First Federal’s adjustable-rate mortgage loans is 2% per adjustment period and the lifetime interest rate cap is generally 5% over the initial interest rate of the loan. First Federal qualifies the borrower based on the borrower’s ability to repay the loan based on the maximum interest rate at the first adjustment. The terms and conditions of the adjustable-rate mortgage loans offered by First Federal, including the index for interest rates, may vary from time to time.

        First Federal’s balloon loans have a five-year term and payments based on an amortization schedule of up to 30 years. The interest rate on First Federal’s balloon loans is fixed for the term of the loan. First Federal typically notifies the borrower in writing 30 days before the end of the loan term of the maturity of the loan and that the loan must be repaid or the term extended. In most instances, a new rate is negotiated to meet market conditions and an extension of the loan is executed for another five-year term with an amortization schedule equal to the original amortization term less the prior balloon term(s). First Federal generally does not extend the loan if the borrower is delinquent or has had a poor payment history.

        First Federal also offers 30-year fixed rate mortgage loans through the Federal Home Loan Bank’s Mortgage Partnership Finance Program. Through this program, mortgage loans are funded and owned by the Federal Home Loan Bank and serviced by First Federal.

        Most loans originated by First Federal conform to Fannie Mae and Freddie Mac underwriting standards. However, First Federal also originates residential mortgage loans that are not originated in accordance with the purchase requirements of Freddie Mac or Fannie Mae. Although such loans satisfy First Federal’s underwriting requirements, they are considered “non-conforming” because they do not satisfy collateral requirements, income and debt ratios, acreage limits, insurance requirements or various other requirements imposed by Freddie Mac and Fannie Mae. Accordingly, First Federal’s non-conforming loans could be sold only after incurring certain costs and/or discounting the purchase price. First Federal, however, currently does not intend to sell its loans. First Federal has historically found that its origination of non-conforming loans has not resulted in high amounts of non-performing loans. In addition, First Federal believes that these loans satisfy a need in First Federal’s local community. As a result, First Federal intends to continue to originate non-conforming loans.

        Adjustable-rate mortgage loans help reduce First Federal’s exposure to changes in interest rates. The retention of balloon loans in First Federal’s loan portfolio, which through the use of extension agreements function like adjustable-rate mortgage loans, also helps reduce First Federal’s exposure to changes in interest rates. There are, however, unquantifiable credit risks resulting from the potential of increased costs due to changed rates to be paid by the borrower. It is possible that during periods of rising interest rates the risk of default on adjustable-rate mortgage loans may increase as a result of repricing and the increased payments required by the borrower. In addition, although adjustable-rate mortgage loans make First Federal’s asset base more responsive to changes in interest rates, the extent of this interest sensitivity is limited by the annual and lifetime interest rate adjustment limits. Because of these considerations, First Federal has no assurance that yields on adjustable-rate mortgage loans will be sufficient to offset increases in First Federal’s cost of funds during periods of rising interest rates. First Federal believes these risks, which have not had a material adverse effect on First Federal to date, are less than the risks associated with holding fixed-rate loans in its portfolio in a rising interest rate environment.

        Multi-family and Commercial Real Estate Loans. Most of the multi-family loans and commercial real estate loans originated by First Federal are five-year and three-year balloon loans with payments based on an amortization schedule of up to 20 years. With limited exception, the maximum loan-to-value ratio for a multi-family or commercial real estate loan is 75%. First Federal requires written appraisals prepared by an approved independent appraiser of all properties located in Quincy, Illinois securing multi-family or commercial real estate loans in amounts over $50,000 and all properties located in the remainder of First Federal’s market area securing multi-family or commercial real estate loans in amounts over $5,000. At December 31, 2002, First Federal’s commercial real estate loans were secured by a variety of properties, including, but not limited to, retail and small office properties, farmland and churches.

        In addition, First Federal also purchases participation interests in multi-family and commercial real estate loans, which are generally adjustable rate loans indexed to the prime rate with terms of up to 25 years.

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        Multi-family and commercial real estate lending affords First Federal an opportunity to receive interest at rates higher than those generally available from one- to four-family residential lending. However, loans secured by these properties usually are greater in amount and are more difficult to evaluate and monitor and, therefore, involve a greater degree of risk than one- to four-family residential mortgage loans. Because payments on loans secured by income producing properties are often dependent on the successful operation and management of the properties, repayment of these loans may be affected by adverse conditions in the real estate market or the economy. First Federal seeks to minimize these risks by generally limiting the maximum loan-to-value ratio to 75% for multi-family and commercial real estate loans and by strictly scrutinizing the financial condition of the borrower, the cash flow of the project, the quality of the collateral and the management of the property securing the loan. First Federal also attempts to minimize credit risk by lending almost solely on local properties to businesses with which First Federal is familiar. First Federal conducts a visual inspection for possible environmental compliance concerns and requires an environmental audit with respect to manufacturing facilities securing any loan over $200,000 and any other property where the inspection discloses possible problems. First Federal also generally obtains personal loan guarantees from financially capable parties.

        Residential Construction Loans. First Federal originates construction loans to professional builders and to individuals for the construction and acquisition of personal residences. Most of First Federal’s construction loans are made to individuals. First Federal’s construction loans generally provide for the payment of interest only during the construction phase, which is usually six months. In the case of loans to individuals, at the end of the construction phase, the loan converts to a permanent mortgage loan. Loans can be made with a maximum loan to value ratio of 80%.

        Before making a commitment to fund a construction loan, First Federal requires an appraisal of the property by a licensed appraiser. First Federal also reviews and inspects each property before disbursement of funds during the term of the construction loan. Loan proceeds are disbursed after inspection based on the percentage of completion.

        Construction lending generally involves a higher degree of risk than single-family permanent mortgage lending because of the greater potential for disagreements between borrowers and builders and the failure of builders to pay subcontractors. Additional risk often exists because of the inherent difficulty in estimating both a property’s value and the estimated cost of the property. If the estimate of construction cost proves to be inaccurate, First Federal may be required to advance funds beyond the amount originally committed to protect the value of the property. If the estimate of value upon completion proves to be inaccurate, First Federal may be confronted with a property whose value is insufficient to assure full repayment. First Federal has attempted to minimize the foregoing risks by, among other things, limiting its construction lending to residential properties, limiting loans to builders for speculative construction projects and by having all construction loans to individuals convert to permanent mortgage loans at the end of the construction phase. It is also First Federal’s general policy to obtain regular financial statements and tax returns from builders so that it can monitor their financial strength and ability to repay.

        Commercial Business Loans. First Federal offers a variety of commercial lending products that include term loans for equipment financing, term loans for business acquisitions, inventory financing and revolving lines of credit. In most cases, fixed-rate loans have terms up to five years and are fully amortizing. Revolving lines of credit generally have adjustable rates of interest and are governed by a borrowing base certificate, payable on demand, subject to annual review and renewal. Business loans with variable rates of interest adjust on a daily basis and generally are indexed to the prime rate as published in The Wall Street Journal. Furthermore, as circumstances warrant, First Federal may utilize a loan agreement for commercial loans.

        In making commercial business loans, First Federal considers a number of factors, including the financial condition of the borrower, the nature of the borrower’s business, economic conditions affecting the borrower, First Federal’s market area, the management experience of the borrower, the debt service capabilities of the borrower, the projected cash flows of the business and the collateral. Commercial loans generally are secured by a variety of collateral, including equipment, inventory and accounts receivable, and are supported by personal guarantees.

        Unlike mortgage loans, which generally are made on the basis of the borrower’s ability to make repayment from his or her employment or other income, and which are secured by real property whose value tends to be more easily ascertainable, commercial loans are larger in amount and of higher risk and typically are made on the basis of the borrower’s ability to repay the loan from the cash flow of the borrower’s business. As a result, the availability of funds for the repayment of commercial loans may be substantially dependent on the success of the business itself. Further, any

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collateral securing such loans may depreciate over time, may be difficult to appraise and may fluctuate in value. To manage these risks, First Federal performs a credit analysis for each commercial loan at least annually. In addition, semi-annual credit reviews occur to continually monitor credit.

        Consumer Loans. First Federal offers a variety of consumer loans, including fully amortized home equity loans and second mortgage loans and automobile loans.

        First Federal offers fixed-rate home improvement loans with terms up to eight years. The home improvement loans are FHA-insured loans in amounts up to $25,000. The loan-to-value ratios of fixed-rate home improvement loans are generally limited to 80%.

        First Federal’s second mortgage loans are generally either five-year, fixed-rate loans or five-year balloon loans. First Federal’s second mortgages are limited to existing First Federal customers. The underwriting standards employed by First Federal for home equity loans and second mortgage loans include a determination of the applicant’s credit history, an assessment of the applicant’s ability to meet existing obligations and payments on the proposed loan and the value of the collateral securing the loan.

        First Federal also originates consumer loans secured by automobiles and, occasionally, boats and other recreational vehicles. First Federal offers fixed-rate automobile loans with terms of up to 60 months. Loan-to-value ratios and maximum loan terms vary depending on the age of the vehicle.

        Other consumer loans offered by First Federal include loans secured by various personal property and share loans. Loans secured by personal property generally have a fixed-rate and a maximum term of five years. Share loans are secured by deposits at First Federal.

        Consumer loans entail greater risk than do residential mortgage loans, particularly in the case of loans that are unsecured or secured by rapidly depreciating assets such as automobiles. In these cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. The remaining deficiency often does not warrant further substantial collection efforts against the borrower beyond obtaining a deficiency judgment. In addition, consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy.

        Loans to One Borrower. The maximum amount that First Federal may lend to one borrower is limited by regulation. At December 31, 2002, First Federal’s regulatory limit on loans to one borrower was $5.7 million. At that date, First Federal’s largest amount of loans to one borrower, including the borrower’s related interests, was approximately $3.5 million and consisted of commercial real estate loans located in First Federal’s market area. These loans were performing according to their original terms at December 31, 2002.

        Loan Originations, Purchases and Sales. First Federal’s lending activities are conducted by its employees operating through First Federal’s offices. First Federal relies on advertising, referrals from realtors and customers, and personal contact by First Federal’s staff to generate loan originations. First Federal does not use loan correspondents or other third-parties to originate loans and, in recent years, has not been an active purchaser of loans. In the past, First Federal purchased whole loans and participation interests in commercial and residential mortgage loans through a mortgage company in Colorado. First Federal has also participated in a small amount of loans through a group of institutions organized to lend to businesses in the Quincy, Illinois business district. In addition, First Federal also purchases participation interests in multi-family and commercial real estate loans, which are generally adjustable rate loans indexed to the prime rate with terms of up to 25 years. Except for loans originated through the Federal Home Loan Bank’s Mortgage Partnership Finance Program, First Federal generally retains for its portfolio all of the loans that it originates.

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        The following table presents total loans originated, purchased and repaid during the periods indicated.

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        Nonperforming Assets and Delinquencies. The following table presents information with respect to First Federal’s nonperforming assets at the dates indicated.

        Interest income that would have been recorded for the year ended December 31, 2002 had nonaccruing loans been current according to their original terms amounted to $17,455. Interest related to these loans of $6,481was included in interest income for the year ended December 31, 2002.

        First Federal ceases accruing interest on loans when principal or interest payments are delinquent 90 days or more unless the loan is adequately collateralized and in the process of collection. Once the accrual of interest on a loan is discontinued, all interest previously accrued is reversed against current period interest income once management determines that interest is uncollectible.

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        The following tables sets forth the delinquencies in First Federal’s loan portfolio as of the dates indicated.

        Real Estate Owned. Real estate acquired by First Federal as a result of foreclosure or by deed-in-lieu of foreclosure is classified as real estate owned until sold. When property is acquired it is recorded at the lower of its cost, which is the unpaid principal balance of the loan plus foreclosure costs, or fair market value at the date of foreclosure, establishing a new cost basis. Holding costs and declines in fair value after acquisition of the property result in charges to expense. At December 31, 2002, First Federal had real estate owned in the amount of $277,000, consisting of single family loans.

        Asset Classification. Federal banking regulators have adopted various regulations and practices regarding problem assets of savings institutions. Under such regulations, examiners have authority to identify problem assets during examinations and, if appropriate, require them to be classified.

        There are three classifications for problem assets: substandard, doubtful and loss. Substandard assets have one or more defined weaknesses and are characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected. Doubtful assets have the weaknesses of substandard assets with the additional characteristic that the weaknesses make collection or liquidation in full on the basis of currently

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existing facts, conditions and values questionable, and there is a high possibility of loss. An asset classified as loss is considered uncollectible and of such little value that continuance as an asset of the institution is not warranted. If an asset or portion thereof is classified as loss, the insured institution establishes specific allowances for loan losses for the full amount of the portion of the asset classified as loss. All or a portion of general loan loss allowances established to cover probable losses related to assets classified substandard or doubtful can be included in determining an institution’s regulatory capital, while specific valuation allowances for loan losses generally do not qualify as regulatory capital. Assets that do not currently expose the insured institution to sufficient risk to warrant classification in one of the aforementioned categories but possess weaknesses are designated “special mention.” First Federal monitors “special mention” assets.

        The following table presents classified assets at December 31, 2002.

        Allowance for Loan Losses. In originating loans, First Federal recognizes that losses will be experienced on loans and that the risk of loss will vary with, among other things, the type of loan being made, the creditworthiness of the borrower over the term of the loan, general economic conditions and, in the case of a secured loan, the quality of the security for the loan. First Federal maintains an allowance for loan losses to absorb losses inherent in the loan portfolio. The allowance for loan losses represents management’s estimate of probable incurred losses based on information available as of the date of the financial statements. The allowance for loan losses is based on management’s evaluation of the collectibility of the loan portfolio, including past loan loss experience, known and inherent risks in the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, and economic conditions.

        The loan portfolio and other credit exposures are regularly reviewed by management to evaluate the adequacy of the allowance for loan losses. The methodology for assessing the appropriateness of the allowance includes comparison to actual losses, peer group comparisons, industry data and economic conditions. In addition, the regulatory agencies, as an integral part of their examination process, periodically review First Federal’s allowance for loan losses. Such agencies may require First Federal to make additional provisions for estimated losses based upon judgments different from those of management.

        In connection with assessing the allowance, loss factors are applied to various pools of outstanding loans. First Federal segregates the loan portfolio according to risk characteristics (i.e., mortgage loans, business, consumer). Loss factors are derived using First Federal’s historical loss experience and may be adjusted for significant factors that, in management’s judgment, affect the collectibility of the portfolio as of the evaluation date. Large dollar commercial real estate and commercial business loans are individually evaluated for impairment and specific reserves are allocated as needed.

        In addition, management assesses the allowance using factors that cannot be associated with specific credit or loan categories. These factors include management’s subjective evaluation of local and national economic and business conditions, portfolio concentration and changes in the character and size of the loan portfolio. The

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allowance methodology reflects management’s objective that the overall allowance appropriately reflects a margin for the imprecision necessarily inherent in estimates of expected credit losses.

        At December 31, 2002, First Federal’s allowance for loan losses represented 0.65% of total loans and 50.89% of nonperforming loans. Although management believes that it uses the best information available to establish the allowance for loan losses, future adjustments to the allowance for loan losses may be necessary and results of operations could be adversely affected if circumstances differ substantially from the assumptions used in making the determinations. Furthermore, while First Federal believes it has established its existing allowance for loan losses in conformity with generally accepted accounting principles, there can be no assurance that regulators, in reviewing First Federal’s loan portfolio, will not request First Federal to increase its allowance for loan losses. In addition, because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing allowance for loan losses is adequate or that increases will not be necessary should the quality of any loans deteriorate as a result of the factors discussed above. Any material increase in the allowance for loan losses may adversely affect First Federal’s financial condition and results of operations.

        The following table presents an analysis of First Federal’s allowance for loan losses.

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        The following table presents the approximate allocation of the allowance for loan losses by loan category at the dates indicated. Management believes that the allowance can be allocated by category only on an approximate basis. The allocation of the allowance to each category is not indicative of future losses and does not restrict the use of any of the allowance to absorb losses in any category.

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Investment Activities

        Under federal law, First Federal has authority to invest in various types of liquid assets, including U.S. Government obligations, securities of various federal agencies and of state and municipal governments, deposits at the Federal Home Loan Bank of Chicago and certificates of deposit of federally insured institutions. Within certain regulatory limits, First Federal may also invest a portion of its assets in corporate securities, including non-mortgage, asset-backed instruments. Savings institutions like First Federal are also required to maintain an investment in Federal Home Loan Bank of Chicago stock. First Federal is required under federal regulations to maintain a minimum amount of liquid assets.

        First Federal’s Board of Directors has the overall responsibility for First Federal’s investment portfolio, including approval of First Federal’s investment policy and appointment of First Federal’s Investment Committee. The Board of Directors reviews, updates and approves First Federal’s investment policy at least quarterly. The Board of Directors also reviews on at least a quarterly basis an investment activities reporting package prepared by the Investment Committee, which provides portfolio activity, risk levels and compliance with risk limits. The Investment Committee is responsible for approving major policies for conducting investment activities, including the establishment of risk limits and also ensures that management has the requisite skills to manage the risks associated with approved investment activities. First Federal’s Chief Executive Officer is authorized to make investment decisions consistent with First Federal’s investment policy and the recommendations of First Federal’s Investment Committee and is primarily responsible for daily investment activities. The Investment Committee generally meets monthly with the Chief Executive Officer in order to review and determine investment strategies and transactions.

        First Federal’s investment policy is designed to complement First Federal’s lending activities, provide an alternative source of income through interest and dividends, diversify First Federal’s assets and improve liquidity. Investment decisions are made in accordance with First Federal’s investment policy and are based upon the quality of a particular investment, its inherent risks, the composition of the balance sheet, market expectations, First Federal’s liquidity, income and collateral needs and how the investment fits within First Federal’s interest rate risk strategy.

        The primary objective of the investment portfolio is to maintain an adequate source of liquidity sufficient to meet regulatory and operating requirements, and to safeguard against deposit outflows, reduced loan amortization and increased loan demand. The investment portfolio primarily includes debt issues and mortgage-backed securities. All of First Federal’s mortgage-backed securities are issued or guaranteed by agencies of the U.S. Government. Accordingly, they carry lower credit risk than mortgage-backed securities of a private issuer. However, mortgage-backed securities still carry market risk, insofar as increases in market interest rates may cause a decrease in market value, and prepayment risk, which is risk that the securities will be repaid before maturity and that First Federal will have to reinvest the funds at a lower interest rate.

        First Federal’s investment portfolio grew in 2001 and 2002 due to the low interest rate environment. This low interest rate environment led to a higher demand for long-term, fixed-rate loans, and caused borrowers to refinance adjustable-rate mortgage loans. First Federal began offering fixed-rate loans in 2000 but still experienced numerous pay-offs due to extreme competition for these loans both locally and nationally. During 2002, First Federal originated $13.9 million of loans funded through the MPF program. This caused an increase in liquidity at First Federal, which First Federal invested in debt and mortgage-backed securities. As market conditions permit, First Federal intends to use funds from the sale and maturity of securities to make new loans or retire debt.

        Generally accepted accounting principles require that securities be categorized as either “held to maturity,” “trading securities” or “available for sale,” based on management’s intent as to the ultimate disposition of each security. Debt securities may be classified as “held to maturity” and reported in financial statements at amortized cost only if the reporting entity has the positive intent and ability to hold those securities to maturity. Securities that might be sold in response to changes in market interest rates, changes in the security’s prepayment risk, increases in loan demand, or other similar factors cannot be classified as “held to maturity.” Debt and equity securities held for current resale are classified as “trading securities.” These securities are reported at fair value, and unrealized gains and losses on the securities would be included in earnings. First Federal does not currently use or maintain a trading

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account. Debt and equity securities not classified as either “held to maturity” or “trading securities” are classified as “available for sale.” These securities are reported at fair value, and unrealized gains and losses on the securities are excluded from earnings and reported, net of deferred taxes, as a separate component of equity.

        At December 31, 2002, First Federal did not own any securities, other than disclosed in the following table, that had an aggregate book value in excess of 10% of First Federal’s retained earnings at that date.

        The following table presents the amortized cost and fair value of First Federal’s securities, by type of security, at the dates indicated.