UNITED
STATES


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
      1934For the fiscal year
      ended December 31,
      2009OR[  ]
            TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934For
      the transition period from  _________________    to  ______________________




COMMISSION
FILE NUMBER 000-52889




Sound
      Financial, Inc.(Exact
      Name of Registrant as Specified in its
Charter)




United
      States
            
            26-0776123(State
      or other jurisdiction of incorporation or organization)
            
            (I.R.S.
      Employer Identification No.)2005
      5th Avenue, Suite 200, Seattle Washington
            
            98121(Address
      of principal executive offices)
            
            (Zip
      Code)




Registrant’s telephone
number, including area code:  (206)
448-0884




Securities
Registered Pursuant to Section 12(b) of the Act:


None




Securities
Registered Pursuant to Section 12(g) of the Act:


Title of
each class


Common
Stock, par value $.01 per share




Indicate
by checkmark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.  YES
[   ]    NO [X]




Indicate
by checkmark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act.  YES
[   ]    NO [X]




Indicate
by checkmark 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
[   ]




Indicate
by checkmark whether the registrant has submitted electronically and posted on
its corporate website, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of
this chapter) during the preceding 12 months (or for such shorter period that
the registrant was required to submit and post such files).   YES
[   ]   NO [   ]




Indicate by checkmark if
disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§
229.405 of this chapter) is not contained herein, and will not be contained, to
the best of 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. [   ] [NOTE
– NO DELINQUENT REPORTS REPORTED UNDER PART III, ITEM 10 OF 10-K.  IF
TRUE, THEN CHECK THIS BOX.]




Indicate
by checkmark whether the registrant is a large accelerated filer, an accelerated
filer, a non-accelerated filer or a smaller reporting Company.  See
definition of “large accelerated filer,” and “smaller reporting Company” in Rule
12b-2 of the Act.




Large
      accelerated filer [  ]
            Accelerated
      filer [  ]
            Non-accelerated
      filer [  ]
            Smaller
      reporting Company [X](Do
      not check if smaller reporting Company)




Indicate
by checkmark whether the registrant is a shell Company (as defined in Rule 12b-2
of the Exchange Act).  YES
[   ]    NO [ X ]




The
aggregate market value of the voting and non-voting common equity held by
non-affiliates as of June 30, 2009, the last business day of the registrant’s
most recently completed second fiscal quarter, was approximately $6.7
million.  (The exclusion from such amount of the market value of the
shares owned by any person shall not be deemed an admission by the registrant
that such person is an affiliate of the registrant.)




Indicate
the number of shares outstanding of each of the registrant’s classes of common
stock as of the latest practicable date.


As
of March 15, 2010, there were 3,000,095 shares of the registrant’s common stock
outstanding.




DOCUMENTS
INCORPORATED BY REFERENCE




PART III
of Form 10-K--Portions of registrant’s Proxy Statement for its 2010 Annual
Meeting of Shareholders.





PART
I




Item
1.                                Business




General




Sound
Financial, Inc. is a federally chartered stock holding Company and is subject to
regulation by the Office of Thrift Supervision (“OTS”).  Sound
Financial, Inc. was organized on January 8, 2008, as part of Sound Community
Bank’s reorganization into the mutual holding Company form of
organization.  As part of the reorganization, Sound Community Bank (i)
converted to a stock savings bank as the successor to Sound Community Bank in
its mutual form (which was originally chartered as a credit union in 1953; (ii)
organized Sound Financial, Inc., which owns 100% of the common stock of Sound
Community Bank; and (iii) organized Sound MHC, which currently owns 54% of the
common stock of Sound Financial, Inc.  Sound MHC has no other
activities or operations other than its ownership of Sound Financial,
Inc.  Sound Community Bank succeeded to the business and operations of
the Company in its mutual form and Sound Financial, Inc. has no significant
assets other than all of the outstanding shares of common stock of Sound
Community Bank, its loan to the Sound Financial, Inc.’s Employee Stock Ownership
Plan, and certain liquid assets.




Unless
the context otherwise requires, references in this document to the “Company” or
“Sound Financial” refer to Sound Financial, Inc. and references to the “Bank”
refer to Sound Community Bank (in its stock or mutual
form).  References to “we,” “us,” and “our” means Sound Financial,
Inc. or Sound Community Bank, unless the context otherwise
requires.




In
connection with the above-mentioned reorganization, Sound Financial sold
1,297,148 shares of common stock in a subscription offering that closed on
January 8, 2008.  Those shares constitute 44% of the outstanding
shares of common stock of Sound Financial.  Sound Financial also
issued 29,480 shares of common stock to Sound Community Foundation, a charitable
foundation created by Sound Community Bank in connection with the mutual holding
Company reorganization and subscription offering.  The remaining
1,621,435 shares of common stock of Sound Financial outstanding were issued in
accordance with federal law to Sound Community MHC, a federal mutual holding
Company (“MHC”).




Substantially
all of Sound Financial’s business is conducted through the Company, which is a
federal savings bank subject to extensive regulation by the
OTS.  Sound Community Bank’s deposits are insured up to applicable
limits by the Federal Deposit Insurance Corporation (“FDIC”).  At
December 31, 2009, we had total consolidated assets of $337.8 million, deposits
of $287.6 million and stockholders’ equity of $25.1 million.  The
shares of Sound Financial are traded on the Over-the-Counter Electronic Bulletin
Board under the symbol “SNFL.”  Our executive offices are located at
2005 5th
Avenue, Seattle, Washington, 98121.




Sound
Community Bank was originally chartered in 1953 as the Associated Grocers
Employees Federal Credit Union.  By the late 1980’s, the members of
the credit union expanded from employees of Associated Grocers to employees of
other businesses.  In the 1990’s, the credit union was serving
employees of approximately 450 small companies.  In 1992, it changed
its name to Credit Union of the Pacific.  On May 19, 2003, Credit
Union of the Pacific converted its charter from a state-chartered credit union
to a federally chartered savings bank.  On that date the name was
changed from Credit Union of the Pacific to Sound Community Bank, and the
Company became a taxable organization.




The
Company’s principal business consists of attracting retail deposits from the
general public and investing those funds, along with borrowed funds, in loans
secured by first and second mortgages on one- to four-family residences
(including home equity loans and lines of credit), commercial real estate,
consumer and commercial business loans and, to a lesser extent, construction and
development loans.  We offer a wide variety of secured and unsecured
consumer loan products, including manufactured home loans, automobile loans,
boat loans and recreational vehicle loans.  We intend to continue
emphasizing our residential mortgage, home equity and consumer lending, while
also expanding our emphasis in commercial real estate and commercial business
lending.  In recent years, we have focused on expanding our commercial
loan portfolio (commercial real estate and other commercial loans), which has
grown to $89.9 million or 31.0% of our loan portfolio at December 31, 2009, from
$66.4 million or 25.2% of our loan portfolio at December 31,
2008.


2




As part
of our business, we focus on mortgage loan originations, many of which we sell
to Fannie Mae.  We sell these loans with servicing retained to
maintain the direct customer relationship and support our emphasis on strong
customer service.  We originated $117.6 million and $57.7 million in
one- to four-family residential mortgage loans during the years ended December
31, 2009 and 2008, respectively.  During these same periods, we sold
$84.3 million and $31.6 million, respectively, of one- to four-family
residential mortgage loans.




We offer
a variety of deposit accounts, which are our primary source of funding for our
lending activities.  In recent years we have also relied on Federal
Home Loan Bank advances to augment our deposits and fund the growth of interest
earning assets.  In 2008, we adopted a leverage strategy to use short
and long-term Federal Home Loan Bank advances to fund asset and loan
growth.




The
Company’s earnings are primarily dependent upon our net interest income, the
difference between interest income and interest expense.  Interest
income is a function of the balances of loans and investments outstanding during
a given period and the yield earned on these loans and
investments.  Interest expense is a function of the amount of deposits
and borrowings outstanding during the same period and interest rates paid on
these deposits and borrowings.  The Company’s earnings are also
affected by our provision for loan losses, service charges and fees, gains and
losses from sales of loans, investments and other assets, other income,
operating expenses and income taxes.




During
2009, the Company expanded its operations through the acquisition of two
branches in Port Angeles and Tacoma, Washington.  In July 2009, the
Company opened a new branch in Port Angeles.  On September 1, 2009,
the Company acquired the Port Angeles and Tacoma offices of 1st Security Bank,
including $33.6 million in deposits.  The operations of the Port
Angeles location were moved to the Company’s new Port Angeles branch, and the
1st
Security Bank branch location was vacated.  The Company’s former
branch in Lakewood was closed and the operations were consolidated with the
leased 1st
Security branch in Tacoma.




Forward-Looking
Statements




This Form
10-K contains various forward-looking statements.  You can identify
these forward-looking statements through our use of words such as ‘may,” “will,”
“anticipate,” “assume,” “should,” “indicate,” “would,” “believe,” “contemplate,”
“expect,” “estimate,” “continue,” “plan,” “project,” “could,” “intend,” “target”
and other similar words and expressions of the future.  These
forward-looking statements include, but are not limited to:




·
            statements
      of our goals, intentions and
expectations;




·
            statements
      regarding our business plans, prospects, growth and operating
      strategies;




·
            estimated
      of our risks and future costs and
benefits.




These
forward-looking statements are based on current beliefs and expectations of our
management and are inherently subject to significant business, economic and
competitive uncertainties and contingencies, many of which are beyond our
control.  In addition, these forward-looking statements are subject to
assumptions with respect to future business strategies and decisions that are
subject to change. The following factors, among others, could cause actual
results to differ materially from the anticipated results or other expectations
expressed in the forward-looking statements:






·
            changes
      in laws or government regulations or policies affecting financial
      institutions, including changes in regulatory fees and capital
      requirements;




·
            general
      economic conditions, either nationally or in our market areas, that are
      worse than expected;




·
            competition
      among depository and other financial
  institutions;




3


·
            changes
      in the prices, values and sales volume of residential and commercial real
      estate in Washington, and in particular the Puget Sound
      Region;




·
            inflation
      and changes in the interest rate environment that reduce our margins or
      reduce the fair value of financial
instruments;




·
            adverse
      changes in the securities markets;




·
            our
      ability to enter new markets successfully and capitalize on growth
      opportunities;




·
            our
      ability to successfully integrate acquired entities, if
    any;




·
            changes
      in consumer spending, borrowing and savings
  habits;




·
            changes
      in our organization, compensation and benefit
  plans;




·
            our
      ability to continue to increase and manage our commercial, multi-family
      and residential real estate loans and commercial business
      loans;




·
            possible
      impairments of securities held by us, including those issued by government
      entities and government sponsored
enterprises;




·
            the
      level of future deposit premium
assessments;




·
            the
      impact of the current recession on our loan portfolio (including cash flow
      and collateral values), investment portfolio, customers and capital market
      activities;




·
            the
      impact of the current governmental effort to restructure the U.S.
      financial and regulatory system;




·
            the
      failure of assumptions underlying the establishment of allowance for
      possible loan losses and other
estimates;




·
            changes
      in the financial performance and/or condition of our borrowers and their
      ability to repay their loans when due;
and




·
            the
      effect of changes in accounting policies and practices, as may be adopted
      by the regulatory agencies, as well as the United States Securities and
      Exchange Commission, the Public Company Accounting Oversight Board, the
      Financial Accounting Standards Board and other accounting standard
      setters.






Because of
these and other uncertainties, our actual future results may be materially
different from the results indicated by these forward-looking
statements.  We do not undertake, and specifically disclaim, any
obligation to publicly revise any forward-looking statements to reflect events
or circumstances after the date of such statements or to reflect the occurrence
of anticipated or unanticipated events.




Market
Area




Our
primary market area is the Puget Sound region.  We are headquartered
in Seattle, Washington and have six retail offices.  Four of our
offices are located within the Seattle-Tacoma-Bellevue Metropolitan Statistical
Area, which consists of King, Pierce and Snohomish counties.  Based on
the most recent branch deposit data provided by the FDIC, our share of deposits
in that market was approximately 0.2%.  Our fifth and sixth offices,
located in Clallam County, have 8.2% of the deposits in that
market.


4




Our
market area includes a diverse population of management, professional and sales
personnel, office employees, manufacturing and transportation workers, service
industry workers and government employees, as well as retired and self-employed
individuals.  The population has a skilled work force with a wide
range of education levels and ethnic backgrounds.  Major employment
sectors include information and communications technology, financial services,
manufacturing, maritime, biotechnology, education, health and social services,
retail trades, transportation and professional services.  The largest
employers headquartered in our market area include the University of Washington,
the Port of Seattle, Boeing, Microsoft, Costco, Amazon.com, Starbucks, Paccar
and Weyerhaeuser.




The
economy of this region has struggled during the past year.  Median
household income and per capita income for our market area are above the state
and national averages, reflecting strong job growth in our market area during
2007.  For the month of December 2009, the Seattle MSA reported an
unemployment rate of 9.1%, as compared to the national average of 10.0%,
according to the latest available information.  A reduction in the
economic growth in our market area can have an adverse impact on the level of
our mortgage, construction and commercial lending as well as our ability to
gather deposits.




Home
prices have also continued to decline over the past year.  According
to Case-Shiller, home prices in the Seattle MSA have decreased by 7.9% between
December 2008 and December 2009.  In recent months, the rate of price
depreciation appears to have slowed as evidenced by the Case-Shiller month to
month decrease of 0.7% between November and December 2009.




The
challenges faced by the consumers and businesses in this region have had an
impact on the Company’s delinquencies and non-performing
assets.  Loans delinquent more than 60 days increased to $4.4 million
or 1.5% as of December 31, 2009 compared to $2.4 million or 0.9% as of December
31, 2008.  Non performing assets increased to $5.0 million or 1.48% of
total assets as of December 31, 2009 compared to $3.0 million or 1.01% as of
December 31, 2008.




Lending
Activities




The
following table presents information concerning the composition of the Company’s
loan portfolio by the type of loan as of the dates indicated.





2009
            
            
            2008
            
            
            2007
            
            
            2006
            
            
            2005Amount
            
            
            Percent
            
            
            Amount
            
            
            Percent
            
            
            Amount
            
            
            Percent
            
            
            Amount
            
            
            Percent
            
            
            Amount
            
            
            PercentReal
      estate loans:One-
      to four-family
            
            $
            107,318
            
            
            
            36.63
            %
            
            $
            90,863
            
            
            
            34.33
            %
            
            $
            84,788
            
            
            
            38.37
            %
            
            $
            86,102
            
            
            
            41.60
            %
            
            $
            75,554
            
            
            
            39.34
            %Home
      equity
            
            
            50,445
            
            
            
            17.22
            
            
            
            54,557
            
            
            
            20.61
            
            
            
            45,374
            
            
            
            20.53
            
            
            
            39,302
            
            
            
            18.99
            
            
            
            28,534
            
            
            
            14.86Commercial
            
            
            72,035
            
            
            
            24.58
            
            
            
            48,730
            
            
            
            18.41
            
            
            
            25,013
            
            
            
            11.32
            
            
            
            17,501
            
            
            
            8.46
            
            
            
            15,548
            
            
            
            8.10Construction
      or development
            
            
            10,000
            
            
            
            3.41
            
            
            
            12,220
            
            
            
            4.62
            
            
            
            8,622
            
            
            
            3.90
            
            
            
            9,459
            
            
            
            4.57
            
            
            
            7,777
            
            
            
            4.05Total
      real estate loans
            
            
            239,798
            
            
            
            81.84
            
            
            
            206,370
            
            
            
            77.97
            
            
            
            163,797
            
            
            
            74.12
            
            
            
            152,364
            
            
            
            73.62
            
            
            
            127,413
            
            
            
            66.35Consumer
      loans:Manufactured
      homes
            
            
            21,473
            
            
            
            7.33
            
            
            
            22,723
            
            
            
            8.58
            
            
            
            22,495
            
            
            
            10.18
            
            
            
            19,785
            
            
            
            9.56
            
            
            
            16,648
            
            
            
            8.67Automobile
            
            
            6,446
            
            
            
            2.20
            
            
            
            10,080
            
            
            
            3.81
            
            
            
            15,078
            
            
            
            6.82
            
            
            
            17,272
            
            
            
            8.35
            
            
            
            18,138
            
            
            
            9.44Credit
      card
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            12,196
            
            
            
            6.35Other
            
            
            7,499
            
            
            
            2.56
            
            
            
            7,871
            
            
            
            2.97
            
            
            
            8,818
            
            
            
            3.99
            
            
            
            9,932
            
            
            
            4.79
            
            
            
            6,478
            
            
            
            3.37Total
      consumer loans
            
            
            35,418
            
            
            
            12.09
            
            
            
            40,674
            
            
            
            15.37
            
            
            
            46,391
            
            
            
            20.99
            
            
            
            46,989
            
            
            
            22.71
            
            
            
            53,460
            
            
            
            27.84Commercial
      business loans
            
            
            17,800
            
            
            
            6.07
            
            
            
            17,668
            
            
            
            6.67
            
            
            
            10,803
            
            
            
            4.89
            
            
            
            7,600
            
            
            
            3.67
            
            
            
            11,168
            
            
            
            5.82Total
      loans
            
            
            293,016
            
            
            
            100.00
            %
            
            
            264,712
            
            
            
            100.00
            %
            
            
            220,991
            
            
            
            100.00
            %
            
            
            206,953
            
            
            
            100.00
            %
            
            
            192,041
            
            
            
            100.00
            %Less:Deferred
      fees and discounts
            
            
            334
            
            
            
            
            
            
            
            43
            
            
            
            
            
            
            
            (65
            )
            
            
            
            
            
            
            12
            
            
            
            
            
            
            
            185Loans
      held for sale
            
            
            2,857
            
            
            
            
            
            
            
            956
            
            
            
            
            
            
            
            822
            
            
            
            
            
            
            
            1,307
            
            
            
            
            
            
            
            1,069Allowance
      for losses
            
            
            3,468
            
            
            
            
            
            
            
            1,306
            
            
            
            
            
            
            
            828
            
            
            
            
            
            
            
            822
            
            
            
            
            
            
            
            1,321Total
      loans, net
            
            $
            286,357
            
            
            
            
            
            
            $
            262,407
            
            
            
            
            
            
            $
            219,406
            
            
            
            
            
            
            $
            204,812
            
            
            
            
            
            
            $
            189,466


5







The
following table shows the composition of our loan portfolio in dollar amounts
and in percentages by fixed and adjustable rate loans at the dates
indicated.





2009
            
            
            2008
            
            
            2007
            
            
            2006
            
            
            2005Amount
            
            
            Percent
            
            
            Amount
            
            
            Percent
            
            
            Amount
            
            
            Amount
            
            
            Percent
            
            
            Amount
            
            
            Percent
            
            
            AmountFixed-
      rate loans:Real
      estate loans:One- to
      four-family(1)
            
            $
            88,201
            
            
            
            30.10%
            
            
            $
            72,439
            
            
            
            27.37%
            
            
            $
            66,335
            
            
            
            30.02%
            
            
            $
            74,159
            
            
            
            35.83%
            
            
            $
            69,100
            
            
            
            35.98%Home
      equity
            
            
            12,009
            
            
            
            4.10
            
            
            
            15,613
            
            
            
            5.90
            
            
            
            17,814
            
            
            
            8.05
            
            
            
            18,159
            
            
            
            8.77
            
            
            
            7,655
            
            
            
            3.99Commercial
            
            
            27,373
            
            
            
            9.34
            
            
            
            26,035
            
            
            
            9.84
            
            
            
            17,250
            
            
            
            7.81
            
            
            
            12,000
            
            
            
            5.80
            
            
            
            11,088
            
            
            
            5.77Construction
      or development
            
            
            9,453
            
            
            
            3.23
            
            
            
            10,323
            
            
            
            3.90
            
            
            
            5,583
            
            
            
            2.53
            
            
            
            7,056
            
            
            
            3.41
            
            
            
            3,461
            
            
            
            1.80Total
      real estate loans
            
            
            137,036
            
            
            
            46.77
            
            
            
            124,410
            
            
            
            47.01
            
            
            
            106,982
            
            
            
            48.41
            
            
            
            111,374
            
            
            
            53.82
            
            
            
            91,304
            
            
            
            47.54Manufactured
      homes
            
            
            21,473
            
            
            
            7.33
            
            
            
            22,723
            
            
            
            8.58
            
            
            
            22,495
            
            
            
            10.18
            
            
            
            19,785
            
            
            
            9.56
            
            
            
            16,648
            
            
            
            8.67Automobile
            
            
            6,446
            
            
            
            2.20
            
            
            
            10,080
            
            
            
            3.81
            
            
            
            15,078
            
            
            
            6.82
            
            
            
            17,272
            
            
            
            8.35
            
            
            
            18,138
            
            
            
            9.44Credit
      card
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            3,138
            
            
            
            1.63Other
      consumer
            
            
            5,926
            
            
            
            2.02
            
            
            
            6,168
            
            
            
            2.33
            
            
            
            7,119
            
            
            
            3.22
            
            
            
            9,148
            
            
            
            4.42
            
            
            
            5,755
            
            
            
            3.00Commercial
      business loans
            
            
            11,157
            
            
            
            11.55
            
            
            
            7,551
            
            
            
            2.85
            
            
            
            5,539
            
            
            
            2.51
            
            
            
            4,121
            
            
            
            1.99
            
            
            
            3,750
            
            
            
            1.95Total
      fixed-rate loans
            
            
            182,038
            
            
            
            62.13
            
            
            
            46,522
            
            
            
            17.57
            
            
            
            157,213
            
            
            
            71.14
            
            
            
            161,700
            
            
            
            78.13
            
            
            
            138,733
            
            
            
            72.24Adjustable-
      rate loans:Real
      estate loans:One-
      to four-family
            
            
            19,117
            
            
            
            6.52
            
            
            
            18,424
            
            
            
            6.96
            
            
            
            18,453
            
            
            
            8.35
            
            
            
            11,942
            
            
            
            5.77
            
            
            
            6,453
            
            
            
            3.36Home
      equity
            
            
            38,435
            
            
            
            13.12
            
            
            
            38,944
            
            
            
            14.71
            
            
            
            27,560
            
            
            
            12.47
            
            
            
            21,143
            
            
            
            10.22
            
            
            
            20,879
            
            
            
            10.87Commercial
            
            
            44,663
            
            
            
            15.24
            
            
            
            22,695
            
            
            
            8.57
            
            
            
            7,764
            
            
            
            3.51
            
            
            
            5,502
            
            
            
            2.66
            
            
            
            4,460
            
            
            
            2.32Construction
      or development
            
            
            547
            
            
            
            0.19
            
            
            
            1,897
            
            
            
            0.72
            
            
            
            3,039
            
            
            
            1.38
            
            
            
            2,403
            
            
            
            1.16
            
            
            
            4,316
            
            
            
            2.25Total
      real estate loans
            
            
            102,762
            
            
            
            35.07
            
            
            
            81,960
            
            
            
            30.96
            
            
            
            56,816
            
            
            
            25.71
            
            
            
            40,990
            
            
            
            19.81
            
            
            
            36,108
            
            
            
            18.80Credit
      card
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            9,058
            
            
            
            4.72Other
      consumer
            
            
            1,573
            
            
            
            0.54
            
            
            
            1,703
            
            
            
            0.64
            
            
            
            1,698
            
            
            
            0.77
            
            
            
            784
            
            
            
            0.38
            
            
            
            724
            
            
            
            0.38Commercial
      business loans
            
            
            6,643
            
            
            
            2.27
            
            
            
            10,117
            
            
            
            3.82
            
            
            
            5,264
            
            
            
            28.86
            
            
            
            3,479
            
            
            
            1.68
            
            
            
            7,418
            
            
            
            3.86Total
      adjustable-rate loans
            
            
            110,978
            
            
            
            37.87
            
            
            
            11,820
            
            
            
            4.46
            
            
            
            63,778
            
            
            
            28.86
            
            
            
            45,253
            
            
            
            21.87
            
            
            
            53,308
            
            
            
            27.76Total
      loans
            
            
            293,016
            
            
            
            100.00%
            
            
            
            264,712
            
            
            
            100.00%
            
            
            
            220,991
            
            
            
            100.00%
            
            
            
            206,953
            
            
            
            100.00%
            
            
            
            192,041
            
            
            
            100.00%Less:Deferred
      fees and discounts
            
            
            334
            
            
            
            
            
            
            
            43
            
            
            
            
            
            
            
            (65
            )
            
            
            
            
            
            
            12
            
            
            
            
            
            
            
            185Loans
      held for sale
            
            
            2,857
            
            
            
            
            
            
            
            956
            
            
            
            
            
            
            
            822
            
            
            
            
            
            
            
            1,307
            
            
            
            
            
            
            
            1,069Allowance
      for losses
            
            
            3,468
            
            
            
            
            
            
            
            1,306
            
            
            
            
            
            
            
            828
            
            
            
            
            
            
            
            822
            
            
            
            
            
            
            
            1,321Total
      loans, net
            
            $
            286,357
            
            
            
            
            
            
            $
            262,407
            
            
            
            
            
            
            $
            219,406
            
            
            
            
            
            
            $
            204,812
            
            
            
            
            
            
            $
            189,466


___________________________


(1)
Includes 30-year loans with a one-time rate adjustment five to seven years after
origination, which at December 31, 2009, totaled $37.9 million, or 43.0% of our
fixed-rate residential mortgages.







6










The
following schedule illustrates the contractual maturity of our loan portfolio at
December 31, 2009.  Mortgages that have adjustable or renegotiable
interest rates are shown as maturing in the period during which the contract is
due.  The schedule does not reflect the effects of possible
prepayments or enforcement of due-on-sale clauses.





Real
      Estate MortgageOne-
      to Four-
              Family
            
            Home
      Equity
              Loans
            
            Commercial
            
            Construction
      to
              Development
            
            Consumer
            
            Commercial
              Business
            
            TotalAmount
            
            Weighted
              Average
              Rate
            
            Amount
            
            Weighted
              Average
              Rate
            
            Amount
            
            Weighted
              Average
              Rate
            
            Amount
            
            Weighted
              Average
              Rate
            
            Amount
            
            Weighted
              Average
              Rate
            
            Amount
            
            Weighted
              Average
              Rate
            
            Amount
            
            Weighted
              Average
              Rate(Dollars
      in thousands)2010(1)
            $
            4,100
            
            4.67
            %
            
            $
            832
            
            6.19
            %
            
            $
            3,877
            
            5.64
            %
            
            $
            4,657
            
            6.50
            %
            
            $
            1,520
            
            11.60
            %
            
            $
            6,130
            
            6.77
            %
            
            $
            21,116
            
            6.42
            %2011
            
            3,066
            
            5.76
            
            
            
            682
            
            5.01
            
            
            
            1,448
            
            5.60
            
            
            
            46
            
            6.75
            
            
            
            1,634
            
            7.82
            
            
            
            1,302
            
            7.12
            
            
            
            8,177
            
            6.302012
            
            6,354
            
            6.29
            
            
            
            387
            
            5.23
            
            
            
            3,557
            
            6.68
            
            
            
            71
            
            10.50
            
            
            
            2,537
            
            8.51
            
            
            
            1,566
            
            7.47
            
            
            
            14,471
            
            6.902013
            
            4,501
            
            7.06
            
            
            
            896
            
            5.67
            
            
            
            1,884
            
            5.54
            
            
            
            9
            
            7.00
            
            
            
            2,261
            
            8.02
            
            
            
            1,257
            
            6.90
            
            
            
            10,807
            
            6.862014
      to 2016
            
            20,660
            
            6.39
            
            
            
            4,465
            
            5.58
            
            
            
            7,299
            
            6.92
            
            
            
            331
            
            7.04
            
            
            
            4,931
            
            7.60
            
            
            
            4,757
            
            6.66
            
            
            
            42,443
            
            6.572017
      to 2020
            
            7,117
            
            5.40
            
            
            
            32,397
            
            5.19
            
            
            
            42,634
            
            6.71
            
            
            
            1,205
            
            6.68
            
            
            
            5,672
            
            8.48
            
            
            
            2,308
            
            8.81
            
            
            
            91,333
            
            6.232021
      to 2024
            
            3,106
            
            5.53
            
            
            
            7,491
            
            6.87
            
            
            
            2,555
            
            6.68
            
            
            
            3,400
            
            7.06
            
            
            
            9,216
            
            8.79
            
            
            
            22
            
            7.38
            
            
            
            25,790
            
            7.402025
      and following
            
            58,414
            
            5.15
            
            
            
            3,296
            
            7.64
            
            
            
            8,781
            
            6.51
            
            
            
            282
            
            6.76
            
            
            
            7,647
            
            7.79
            
            
            
            457
            
            7.27
            
            
            
            78,877
            
            5.68Total
            $
            107,318
            
            5.56
            %
            
            $
            50,445
            
            5.66
            %
            
            $
            72,035
            
            6.60
            %
            
            $
            10,000
            
            6.77
            %
            
            $
            35,418
            
            8.37
            %
            
            $
            17,800
            
            7.12
            %
            
            $
            293,016
            
            6.31
            %


___________________________________________


(1)  Includes
demand loans, loans having no stated maturity, overdraft loans and loans held
for sale.




The total
amount of loans due after December 31, 2010, which have predetermined interest
rates, is $168.7 million, while the total amount of loans due after such date,
which have floating or adjustable interest rates is $103.2 million.




Lending
Authority.  The President/CEO may approve unsecured loans up to
$500,000 and all types of secured loans up to $1.0 million. The EVP/Chief Credit
Officer may approve all other secured loans up to $500,000. The SVP/Lending also
may approve secured consumer loans and residential mortgage and construction and
development loans (excluding commercial loans) up to $500,000. The SVP/Lending,
EVP/Chief Credit Officer each may approve unsecured loans up to $250,000. The
President/CEO, EVP/Chief Credit Officer, and SVP/Lending all have an additional
discretionary lending authority equal to 20% of their secured lending limit. Any
loans over the President/CEO’s lending authority or loans otherwise outside our
general underwriting guidelines must be approved by the Board Loan
Committee.




Largest Borrowing
Relationships. At December 31, 2009, the maximum amount under federal law
that we could lend to any one borrower and the borrower’s related entities was
approximately $4.3 million.  Of our five largest borrowing
relationships, four of them are primarily business relationships and one
relationship is with an individual borrower. Our four largest commercial
relationships totaled $12.9 million in the aggregate, or 4.45% of our $290.2
million loan portfolio, at December 31, 2009. The largest relationship consists
of $3.7 million in loans to an individual and his businesses, which are
collateralized by a mortgage on his home and gas stations. The next four largest
lending relationships at December 31, 2009, were $3.5 million in loans to an
individual, which is collateralized by residential property; $3.2 million in
loans to an individual and his businesses which are collateralized by gas
stations;  $3.1 million in loans to a business collateralized by
commercial real estate and multi-family housing; and $2.9 million to a business
collateralized by multi-family housing. All of these loans were current as of
December 31, 2009.  At December 31, 2009, we had no other lending
relationships that exceeded $2.8 million.





7







One- to
Four-Family Real Estate Lending.  We originate loans secured by
first mortgages on one- to-four family residences primarily located in our
geographic lending area.  We originate one- to four-family residential
mortgage loans primarily through referrals from real estate agents, builders and
from existing customers.  Walk-in customers to our branches are
another important source of loan origination for us.




A portion
of the one- to four-family loans we originate are retained in our portfolio and
others are sold into the secondary market, with servicing retained for continued
customer contact and service.  This mortgage banking element of our
residential lending business allows us to originate more loans with the same
funds by reinvesting sales proceeds in more residential mortgage
loans.  The sale of mortgage loans reduces our interest rate risk,
provides a stream of servicing income that improves earnings, enhances liquidity
and enables us to originate more loans at our current capital level than if we
held them in portfolio. We currently sell a portion of our residential mortgage
loans, including conforming fixed-rate loans, on a servicing retained
basis.  See “- Loan Originations, Purchases, Sales, Repayments and
Servicing.”  At December 31, 2009, one- to four-family residential
mortgage loans (including loans held for sale) totaled $107.3 million, or 36.6%,
of our gross loan portfolio.




We
generally underwrite our one- to-four family loans based on the applicant’s
employment and credit history and the appraised value of the subject
property.  We generally lend up to 90% of the lesser of the appraised
value or purchase price for one- to four-family first mortgage loans, and up to
80% for non-owner occupied first mortgage loans.  For first mortgage
loans with a loan-to-value ratio in excess of 90%, we generally require private
mortgage insurance in order to reduce our exposure. Second mortgages on one- to
four-family residences, whether owner occupied or not, are made up to 90% of the
appraised value.  Properties securing our one- to four-family loans
are generally appraised by independent fee appraisers who are selected in
accordance with criteria approved by the Board of Directors.  We
require our borrowers to obtain title and hazard insurance, and flood insurance,
if necessary.




We
currently originate one- to four-family mortgage loans with either fixed or
adjustable rates. Our pricing strategy for mortgage loans includes establishing
interest rates that are competitive with other local financial institutions and
consistent with our internal asset and liability management
objectives.  During the year ended December 31, 2009, we originated
$114.4 million of one- to four-family fixed-rate mortgage loans and $3.2 million
of one- to four-family adjustable rate mortgage (ARM) loans.




Fixed-rate
loans secured by one- to four-family residences have contractual maturities of
up to 30 years and are generally fully amortizing, with payments due
monthly.  Currently, ARM loans are offered with annual adjustments and
life-time rate caps that vary based on the product, generally with a maximum
annual rate change of 2.0% and a maximum overall rate change of
6.0%.  We generally use the rate on one-year Treasury Bills to reprice
our ARM loans.  As a consequence of using caps, the interest rates on
these loans may not be as rate sensitive as our cost of funds.




ARM loans
generally pose different credit risks than fixed-rate loans, primarily because
as interest rates rise, the borrower’s payment rises, which increases the
potential for default. The majority of these loans have been originated within
the past several years, when rates were historically low.  We have
offered some teaser rates for the initial loan rate on our ARM loans but not at
significant discounts from our prevailing rates.  See “- Asset Quality
– Non-performing Assets” and “– Classified Assets.”




Most of
our loans are written using generally accepted underwriting guidelines, and are
readily saleable to Fannie Mae or other private investors.  Our real
estate loans generally contain a “due on sale” clause allowing us to declare the
unpaid principal balance due and payable upon the sale of the security
property.  The average size of our one- to four-family residential
loans was approximately $192,000 at December 31, 2009.





8







Home Equity
Lending.  We originate home
equity loans that consist of both fixed-rate loans and variable-rate lines of
credit. We originate home equity lines of credit in amounts of up to 95% of the
value of the collateral, minus any senior liens on the property. Home equity
lines of credit are originated for up to $250,000 with an adjustable rate of
interest, based on the one-year Treasury Bill rate plus a
margin.  Home equity lines of credit generally have up to a
twelve-year draw period, during which time the funds may be paid down and
redrawn up to the committed amount.  Once the draw period has lapsed,
the payment is amortized over a twelve-year period based on the loan balance at
that time.  We charge a $50 annual fee on each outstanding home equity
line of credit and require monthly interest-only payments on the entire drawn
amount. At December 31, 2009, home equity lines of credit totaled $39.1 million
and home equity loans totaled $11.3 million, or 17.2% of our gross loan
portfolio. At December 31, 2009, unfunded commitments on these lines of credit
totaled $21.1 million.




Our
fixed-rate home equity loans are originated in amounts, together with the amount
of the existing first mortgage, of up to 90% of the appraised value of the
subject property for home equity loans.  These loans may have terms of
up to 20 years and are fully amortizing.




Commercial Real
Estate Lending.  We offer a variety of commercial real estate
loans.  Most of these loans are secured by commercial income producing
properties, including retail centers, multi-family apartment buildings,
warehouses, and office buildings located in our market areas.  At
December 31, 2009, commercial real estate loans totaled $72.0 million, or 24.6%,
of our gross loan portfolio, compared to $48.7 million, or 18.4% of our gross
loan portfolio at December 31, 2008.




Our loans
secured by commercial real estate are generally originated with a variable
interest rate, fixed for a five-year term and a 20- to 25- year amortization
period.  At the end of the initial five-year term, there is a balloon
payment or the loan re-prices based on an independent index plus a margin of 1%
to 2% for another five years.  Loan-to-value ratios on our commercial
real estate loans typically do not exceed 80% of the lower of cost or appraised
value of the property securing the loan at origination.




Loans
secured by commercial real estate are generally underwritten based on the net
operating income of the property and the financial strength of the
borrower.  The net operating income, which is the income derived from
the operation of the property less all operating expenses, must be sufficient to
cover the payments related to the outstanding debt plus an additional coverage
requirement.  We generally require at minimum the personal guaranty of
the borrower and an assignment of rents or leases in order to be assured that
the cash flow from the project will be used to repay the
debt.  Appraisals on properties securing commercial real estate loans
are performed by independent state certified or licensed fee appraisers and
approved by the Board Loan Committee. In order to monitor the adequacy of cash
flows on income-producing properties, the borrower is required to provide at
minimum annual financial information.




Loans
secured by commercial real estate properties generally involve a greater degree
of credit risk than one- to four-family residential mortgage
loans.  These loans typically involve larger balances to single
borrowers or groups of related borrowers.  Because payments on loans
secured by commercial and multi-family real estate properties are often
dependent on the successful operation or management of the properties, repayment
of these loans may be subject to adverse conditions in the real estate market or
the economy.  If the cash flow from the project is reduced, or if
leases are not obtained or renewed, the borrower’s ability to repay the loan may
be impaired.  Our largest commercial real estate loan at December 31,
2009, totaled $3.7 million loans to an individual and his business, which is
collateralized by gas stations and a personal residence. At December 31, 2009,
this loan was performing in accordance with the terms of the notes.





9







Construction or
Development LendingWe originate
construction loans secured by single-family residences and commercial real
estate.  We also originate loans secured by tracts of land for
development.  At December 31, 2009, our construction and development
loans totaled $10.0 million, or 3.4%, of our gross loan portfolio.




Construction
loans to individuals and contractors for the construction and acquisition of
personal residences totaled $1.3 million, or 13.0%, of our construction and
development portfolio.  At December 31, 2009, the unadvanced portion
of these construction loans totaled $2.4 million.




Our
construction loans generally provide for the payment of interest only during the
construction phase, which is typically up to nine months.  At the end
of the construction phase, the construction loan generally either converts to a
longer term mortgage loan or is paid off through a permanent loan from another
lender.  Construction loans are made up to the lesser of a maximum
loan-to-value ratio of 100% of cost or 80% of appraised value at
completion.  At December 31, 2009, our largest residential
construction mortgage loan commitment was for $1.9 million; $541,000 of which
had been disbursed. This loan was performing according to its
terms.  The average outstanding residential construction loan balance
was approximately $162,000 at December 31, 2009.




Before
making a commitment to fund a residential construction loan, we require an
appraisal of the subject property by an independent licensed
appraiser.  Loan proceeds are disbursed after inspection based on the
percentage of completion method. We also independently review and inspect each
project before disbursement of funds during the term of the construction
loan.




We make
development loans to builders or residential lot developers.  These
loans involve a higher degree of credit risk similar to commercial construction
loans.  At December 31, 2009, we had a total of $4.4 million in
development loans to builders and residential lot developers. Our largest
development loan being a $1.2 million loan, which is non-performing as of
December 31, 2009. These land loans also involve additional risks because the
loan amount is made based on the projected value of the lots after
construction.  We make these loans for up to 75% of the estimated
value for up to two years.  We require these loans to be paid on an
accelerated basis as the lots are sold, so that we are repaid before all the
lots are sold.




We offer
commercial real estate construction loans for small retail
properties.  These loans are underwritten with terms similar to our
permanent commercial real estate loans with special construction financing for
up to 12 months under terms similar to our residential construction
loans.  We had no construction loans secured by commercial real estate
at December 31, 2009.




Construction
financing is generally considered to involve a higher degree of credit risk than
longer-term financing on improved, owner-occupied real estate.  Risk
of loss on a construction loan depends largely upon the accuracy of the initial
estimate of the value of the property at completion of construction compared to
the estimated cost (including interest) of construction and other
assumptions.  If the estimate of construction costs is inaccurate, we
may be required to advance funds beyond the amount originally committed in order
to protect the value of the property.  Additionally, if the estimate
of value is inaccurate, we may be confronted with a project that, when
completed, has a value that is insufficient to generate full
payment.




Consumer
Lending.  We offer a variety of secured consumer loans,
including new and used manufactured homes, automobiles, motorcycles, boats and
recreational vehicle loans, and loans secured by savings deposits.  We
also offer unsecured consumer loans.  We originate our consumer loans
primarily in our geographic lending areas.





10







We
originate new and used manufactured home loans.  The yields on these
loans are higher than that on our other residential lending products and the
portfolio has performed reasonably well with an acceptable level of risk and
loss in exchange for the higher yield.  Our weighted average yield on
manufactured home loans at December 31, 2009 was 8.5%, compared to 5.6% for one-
to four-family residential mortgages, including loans held for sale. At December
31, 2009, these loans totaled $21.5 million, or 60.6% of our consumer loans and
7.3% of our total loan portfolio. These loans are generally made for up to 90%
of the lesser of the appraised value or purchase price up to $200,000, and with
terms typically up to 20 years.  We generally charge a 1% fee at
origination.  All our manufactured home loans are made on a direct
basis.  We underwrite these loans based on our review of
creditworthiness of the borrower, including credit scores, and the value of the
collateral, for which we perfect a security interest under Washington
law.




Manufactured
home loans are higher risk than loans secured by residential real property,
though this risk is reduced if the owner also owns the land on which the home is
located.  A small portion of our manufactured home loans involve
properties on which we also have financed the land for the owner.  The
primary additional risk in manufactured home loans is the difficulty in
obtaining adequate value for the collateral due to the cost and limited ability
to move the collateral.  These loans tend to be made to retired
individuals and first-time homebuyers.  First-time homebuyers of
manufactured homes tend to be a higher credit risk than first-time homebuyers of
single family residences, due to more limited financial resources.  As
a result, these loans have a higher probability of default, higher delinquency
rates and greater servicing and collateral recovery costs than single family
residential loans and other types of consumer loans.  We maintain a
reserve to address this additional risk.  We attempt to workout
delinquent loans with the borrower and, if that is not successful, any
repossessed manufactured homes are repossessed and sold.  At December
31, 2009, none of our manufactured home loans were non-performing.




We make
loans on new and used automobiles.  Our automobile loan portfolio
totaled $6.4 million at December 31, 2009, or 18.2% of our consumer loan
portfolio and 2.2% of our gross loan portfolio. Automobile loans may be written
for a term of up to seven years for new cars and six years for used cars and
have fixed rates of interest.  Loan-to-value ratios are up to 100% of
the lesser of the purchase price or the National Automobile Dealers Association
value for auto loans, including tax, licenses, title and mechanical breakdown
and gap insurance.  We follow our internal underwriting guidelines in
evaluating automobile loans, including credit scoring, verification of
employment, reviewing debt to income ratios and valuation of the underlying
collateral.




Our
consumer loans also include loans secured by new and used boats, motorcycles and
recreational vehicles, loans secured by deposits and unsecured consumer loans,
all of which, at December 31, 2009, totaled $7.5 million, or 2.6% of our
gross loan portfolio. Loans secured by boats, motorcycles and recreational
vehicles typically have terms from five to 15 years, depending on the
collateral, and loan-to-value ratios up to 90%.  They are made with
fixed rates.  Our unsecured consumer loans have either a fixed rate of
interest generally for a maximum term of 48 months, or are revolving lines of
credit of generally up to $5,000.  At December 31, 2009, unfunded
commitments on our unsecured consumer lines of credit totaled $2.7
million.




Consumer
loans (other than our manufactured homes) generally have shorter terms to
maturity, which reduces our exposure to changes in interest rates.  In
addition, management believes that offering consumer
loan products helps to expand and create stronger ties to our existing customer
base by increasing the number of customer relationships and providing
cross-marketing opportunities.




Consumer
loans generally entail greater risk than do one- to four-family residential
mortgage loans, particularly in the case of consumer loans that are secured by
rapidly depreciable assets, such as manufactured homes, automobiles, boats and
recreational vehicles.  In these cases, any repossessed








11








collateral
for a defaulted loan may not provide an adequate source of repayment of the
outstanding loan balance.  As a result, 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.




Until
June 2006, we engaged in unsecured consumer lending in the form of a VISA credit
card portfolio.  This portfolio offered a higher yield than many of
our other loan products; however, it also involved higher credit risk and
servicing costs than these other products.  In early 2006, we
evaluated the benefits and costs of offering credit cards in this fashion and
decided to offer the service to our existing and potential new customers through
a third party provider.  Beginning in July 2006, our customers
obtained VISA credit cards with the Sound Community Bank brand through an
unaffiliated commercial bank.  That bank also incurs the operating
expenses and the credit risk for the credit card indebtedness of our
customers.  In connection with this shift to a third party provider,
we sold our existing $11.6 million credit card portfolio on June 30, 2006 to
that unaffiliated bank for a pre-tax gain of $2.3 million.  We
continue to earn a percentage of interchange fees and commissions on new
accounts.  In addition, the third party provider continues providing
us with 1% of the purchase transactions on our co-branded credit card accounts,
which we in turn donate to The Sequim Foundation and People for Puget Sound (two
local charities).




Commercial
Business Lending.  At December 31, 2009, commercial business
loans totaled $17.8 million, or 6.1%, of our gross loan portfolio. Our
commercial business lending activities encompass loans with a variety of
purposes and security, including loans to finance commercial vehicles and
equipment.  Approximately $1.2 million of our commercial business
loans are unsecured.  Our commercial business lending policy includes
credit file documentation and analysis of the borrower’s background, capacity to
repay the loan, the adequacy of the borrower’s capital and collateral, as well
as an evaluation of other conditions affecting the borrower.  Analysis
of the borrower’s past, present and future cash flows is also an important
aspect of our credit analysis.  We generally require personal
guarantees on both our secured and unsecured commercial business
loans.  Nonetheless, commercial business loans are believed to carry
higher credit risk than residential mortgage loans.




Unlike
residential mortgage loans, commercial business loans, particularly unsecured
loans, are made on the basis of the borrower’s ability to make repayment from
the cash flow of the borrower’s business and, therefore, are of higher
risk.  We make secured commercial business loans with business assets,
such as accounts receivable, inventory equipment and cash as collateral with
loan-to-value ratios of up to 80%, based on the type of
collateral.  This collateral depreciates over time, may be difficult
to appraise and may fluctuate in value based on the specific type of business
and equipment used.  As a result, the availability of funds for the
repayment of commercial business loans may be substantially dependent on the
success of the business itself (which, in turn, is often dependent in part upon
general economic conditions).




Interest
rates on commercial business loans are usually adjustable and are based on the
prime rate as reported in the West Coast edition of the Wall Street Journal
plus 1% to 2%.  In addition, we typically charge loan fees of 1% to 2%
of the principal amount at origination, depending on the credit quality and
account relationships of the borrower.  Some of our commercial
business loans are lines of credit with terms of
12 months and interest-only monthly payments during the term.  The
remainder are term loans of three to seven years.




Substantially
all of our commercial business loans have been to borrowers in our market
area.  We intend to continue our commercial business lending in this
geographic area.






12







Loan
Originations, Purchases, Sales, Repayments and Servicing






We
originate both fixed-rate and adjustable-rate loans.  Our ability to
originate loans, however, is dependent upon customer demand for loans in our
market areas.  Over the past few years, we have continued to originate
residential and consumer loans, and increased our emphasis on commercial real
estate, construction and development, and commercial business
lending.  Demand is affected by competition and the interest rate
environment.  During the past few years, we, like many other financial
institutions, have experienced significant prepayments on loans due to the low
interest rate environment prevailing in the United States.  In periods
of economic uncertainty, the ability of financial institutions, including us, to
originate large dollar volumes of real estate loans may be substantially reduced
or restricted, with a resultant decrease in interest income. In 2009, we
acquired $4.2 million of seasoned multi-family residential real estate loans. We
acquired these loans at par.  In 2008, we purchased approximately $10
million of seasoned non-residential real estate loans.  We have not
engaged in any loan participations recently, but we may do so in the
future.




In
addition to interest earned on loans and loan origination fees, we receive fees
for loan commitments, late payments and other miscellaneous
services.




We also
sell whole residential real estate loans without recourse to Fannie Mae, subject
to a provision for repurchase upon breach of representation, warranty or
covenant.  These loans are fixed-rate mortgages, which primarily are
sold to improve our interest rate risk.  These loans are generally
sold for cash in amounts equal to the unpaid principal amount of the loans
determined using present value yields to the buyer.  These sales allow
for a servicing fee on loans when the servicing is retained by
us.  Most residential real estate loans sold by us are sold with
servicing retained.  We earned mortgage servicing income of $991,000,
$334,000 and $315,000, respectively, for the years ended December 31, 2009, 2008
and 2007.  On November 30, 2009, we acquired a $340.1 million loan
servicing portfolio from Leader Financial Services.  These loans are
100% owned by Fannie Mae and are subserviced under an agreement with a third
party loan servicer who will perform all servicing including payment processing,
reporting and collections. At December 31, 2009, we were servicing a $510.9
million portfolio of residential mortgage loans for Fannie Mae.  These
mortgage servicing rights are separated into two segments, one for acquired
servicing rights of $2.0 million, which are carried at fair value and one for
our originated servicing portfolio of $1.3 million, which is carried at
amortized cost and is periodically evaluated for impairment based on their fair
value, which takes into account the rates and potential prepayments of those
sold loans being serviced. See Note 6 to the Consolidated Financial
Statements.




Sales of
whole real estate loans and participations in real estate loans can be
beneficial to us since these sales generally generate income at the time of
sale, produce future servicing income on loans where servicing is retained,
provide funds for additional lending and other investments, and increase
liquidity.  We sold $84.3 million, $31.6 million and $25.6 million of
these loans during the years ended December 31, 2009, 2008 and 2007,
respectively.




Gains,
losses and transfer fees on sales of residential real estate loans and
participations are recognized at the time of the sale.  Our net gain
(loss) on sales of residential loans for all of 2009, 2008 and 2007 were
$157,000, ($16,000) and $11,000, respectively.





13







The
following table shows our loan origination, sale and repayment activities for
the periods indicated.  Approximately $4.2 and $9.8 million in loans
were purchased for the year ended December 31, 2009 and 2008, respectively.
There were no loans purchased for the years ended December 31,
2007.




For
      the year ended December 31,2009
            
            
            2008
            
            
            2007(In
      thousands)Originations by
      type:Fixed-rate:One-
      to four-family real estate
            
            $
            111,745
            
            
            $
            54,024
            
            
            $
            30,601Home
      equity
            
            
            1,146
            
            
            
            4,035
            
            
            
            5,768Commercial
      real estate
            
            
            6,969
            
            
            
            13,072
            
            
            
            10,391Construction
      and development
            
            
            3,997
            
            
            
            2,574
            
            
            
            2,531Consumer
            
            
            4,309
            
            
            
            7,579
            
            
            
            12,012Commercial
      business
            
            
            6,597
            
            
            
            5,212
            
            
            
            3,404Total
      fixed-rate
            
            
            134,763
            
            
            
            86,496
            
            
            
            64,707Adjustable
      rate:One-
      to four-family real estate(1)
            
            
            3,171
            
            
            
            3,658
            
            
            
            9,221Home
      equity
            
            
            3,558
            
            
            
            13,547
            
            
            
            11,300Commercial
      real estate
            
            
            19,961
            
            
            
            18,140
            
            
            
            5,081Construction
      and development
            
            
            38
            
            
            
            1,128
            
            
            
            1,919Consumer
            
            
            27
            
            
            
            151
            
            
            
            389Commercial
      business
            
            
            1,917
            
            
            
            1,515
            
            
            
            2,793Total
      adjustable-rate
            
            
            28,645
            
            
            
            38,139
            
            
            
            30,704Total
      loans originated
            
            
            163,435
            
            
            
            124,635
            
            
            
            95,411Purchases by
      type:Commercial
      real estate
            
            
            4,199
            
            
            
            9,731
            
            
            
            ---Sales and
      Repayments:One-
      to four-family real estate
            
            
            84,299
            
            
            
            31,552
            
            
            
            25,644Total
      loans sold
            
            
            84,299
            
            
            
            31,552
            
            
            
            25,644Total
      principal repayments
            
            
            53,129
            
            
            
            59,093
            
            
            
            55,728Total
      reductions
            
            
            137,428
            
            
            
            90,645
            
            
            
            81,373Net
      increase (decrease)
            
            $
            30,206
            
            
            $
            43,721
            
            
            $
            14,038


__________________________


(1)       These
loans include $2.3 million, $1.9 million and $3.4 million, respectively, of
adjustable rate mortgage loan originations to employees at December 31, 2009,
2008 and 2007.








14





Asset
Quality




When a
borrower fails to make a required payment on a residential real estate loan, we
attempt to cure the delinquency by contacting the borrower.  In the
case of loans secured by residential real estate, a late notice typically is
sent within 15 days after the due date, and the borrower is contacted by phone
within 30 days after the due date.  Generally, a delinquency letter is
mailed to the borrower.  All delinquent accounts are reviewed by a
loan officer who attempts to cure the delinquency by contacting the borrower
once the loan is 30 days past due.  If the account becomes 60 days
delinquent and an acceptable repayment plan has not been agreed upon, we
generally refer the account to legal counsel with instructions to prepare a
notice of intent to foreclose.  The notice of intent to foreclose
allows the borrower up to 30 days to bring the account current.  If
foreclosed, typically we take title to the property and sell it directly through
a real estate broker.




Delinquent
consumer loans, as well as delinquent home equity loans and lines of credit, are
handled in a similar manner to residential real estate loans, except that
appropriate action may be taken to collect any loan payment that is delinquent
for more than 15 days.  Once the loan is 90 days past due, it is
classified as nonaccrual.  Generally, credits are charged-off at 120
days past due, unless the Collections Department provides support for continuing
its collection efforts.  Our procedures for repossession and sale of
consumer collateral are subject to various requirements under the applicable
consumer protection laws as well as other applicable laws and the determination
by us that it would be beneficial from a cost basis.




Delinquent
loans are initially handled by the loan officer in charge of the loan, who is
responsible for contacting the borrower.  The Collections Department
also works with the loan officers to see that the necessary steps are taken to
collect delinquent loans.  In addition, management meets weekly and
reviews past due and classified loans, as well as other loans that management
feels may present possible collection problems, which are reported to the board
on a quarterly basis.  If an acceptable workout of a delinquent loan
cannot be agreed upon, we generally initiate foreclosure or repossession
proceedings on any collateral securing the loan.




Delinquent
Loans.The
following table sets forth our loan delinquencies by type, by amount and by
percentage of type at December 31, 2009.




Loans
      Delinquent For:60-89
      Days
            
            
            90
      Days and Over
            
            
            Total
      Delinquent LoansNumber
            
            
            Amount
            
            
            Percent
              of
      Loan
              Category
            
            
            Number
            
            
            Amount
            
            
            Percent
              of
      Loan
              Category
            
            
            Number
            
            
            Amount
            
            
            Percent
              of
      Loan
              Category(Dollars
      in Thousands)One-
      to four-family real
              estate
            
            
            4
            
            
            $
            676
            
            
            
            0.63
            %
            
            
            6
            
            
            $
            1,457
            
            
            
            1.36
            %
            
            
            10
            
            
            $
            2,133
            
            
            
            1.99
            %Home
      Equity
            
            
            2
            
            
            
            84
            
            
            
            0.17
            
            
            
            5
            
            
            
            791
            
            
            
            1.57
            
            
            
            7
            
            
            
            876
            
            
            
            1.73Commercial
      Real Estate
            
            
            -
            
            
            
            -
            
            
            
            0.00
            
            
            
            1
            
            
            
            111
            
            
            
            0.15
            
            
            
            1
            
            
            
            111
            
            
            
            0.15Construction
      and Development
            
            
            -
            
            
            
            -
            
            
            
            0.00
            
            
            
            1
            
            
            
            1,231
            
            
            
            12.31
            
            
            
            1
            
            
            
            1,231
            
            
            
            12.31Consumer
            
            
            16
            
            
            
            60
            
            
            
            0.17
            
            
            
            5
            
            
            
            17
            
            
            
            0.05
            
            
            
            21
            
            
            
            77
            
            
            
            0.22Commercial
      Business
            
            
            -
            
            
            
            -
            
            
            
            0.00
            
            
            
            -
            
            
            
            -
            
            
            
            0.00
            
            
            
            -
            
            
            
            -
            
            
            
            0.00Total
            
            
            22
            
            
            $
            819
            
            
            
            0.28
            %
            
            
            18
            
            
            $
            3,607
            
            
            
            1.23
            %
            
            
            40
            
            
            $
            4,427
            
            
            
            1.51
            %





15







The
dollar amount of delinquent loans increased as of December 31, 2009 (40 loans
totaling $4.4 million) compared to December 31, 2008 (44 loans totaling $2.4
million). At the end of 2008, delinquencies consisted of one-to-four family
mortgages, commercial real estate and consumer loans. At the end of 2009, we had
these three types of delinquent loans, but we also had a lower amount of
consumer delinquencies due to a higher emphasis on early collection efforts by
the loan officer who originated the loan.  In addition, delinquent
loans included home equity, construction and development and commercial business
loans.  Delinquencies in these categories reflect the declining
economic conditions in our market during 2009.




Non-performing
Assets.  The table below
sets forth the amounts and categories of non-performing assets in our loan
portfolio.  Loans are placed on non-accrual status when the collection
of principal and/or interest become doubtful or when the loan is more than 90
days past due.  Foreclosed assets include assets acquired in
settlement of loans.




December
      31,2009
            
            
            2008
            
            
            2007
            
            
            2006
            
            
            2005(Dollars
      in thousands)Non-accruing
      loans:One-
      to four-family
            
            $
            1,457
            
            
            $
            258
            
            
            $
            256
            
            
            $
            132
            
            
            $
            ---Home
      equity
            
            
            791
            
            
            
            340
            
            
            
            ---
            
            
            
            ---
            
            
            
            20Commercial
      Real Estate
            
            
            111
            
            
            
            471
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---Construction
      or Development
            
            
            1,231
            
            
            
            59
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---Consumer
            
            
            17
            
            
            
            64
            
            
            
            162
            
            
            
            160
            
            
            
            109Commercial
      Business
            
            
            ---
            
            
            
            60
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---Total
            
            
            3,607
            
            
            
            1,252
            
            
            
            418
            
            
            
            292
            
            
            
            129Accruing
      loans delinquent more
              than 90
      days:One-
      to four-family
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            129Consumer
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            191Total
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            320Foreclosed
      assets:One-
      to four-family
            
            
            901
            
            
            
            1,250
            
            
            
            817
            
            
            
            ---
            
            
            
            ---Land
            
            
            115
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---Commercial
      business
            
            
            ---
            
            
            
            190
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---Consumer
            
            
            368
            
            
            
            284
            
            
            
            35
            
            
            
            106
            
            
            
            ---Total
            
            
            1,384
            
            
            
            1,724
            
            
            
            852
            
            
            
            106
            
            
            
            ---Total
      non-performing assets
            
            $
            4,991
            
            
            $
            2,976
            
            
            $
            1,270
            
            
            $
            398
            
            
            $
            449Total
      as a percentage of total assets
            
            
            1.48
            %
            
            
            1.01
            %
            
            
            0.54
            %
            
            
            0.18
            %
            
            
            0.22
            %




For the
year ended December 31, 2009, gross interest income that would have been
recorded had the non-accruing loans been current in accordance with their
original terms amounted to $203,000, which was included in interest income for
the year ended December 31, 2009.




Troubled Debt
Restructured Loans. Troubled debt restructurings, which are accounted for
under ASC 310-40, are loans which have renegotiated loan terms to assist
borrowers who are unable to meet the original terms of their
loans.  Such modifications to loan terms may include a lower interest
rate, a reduction in principal, or a longer term to maturity.  All
troubled debt restructurings are initially classified as impaired, regardless of
whether the loan was performing at the time it was restructured.  Once
a





16







troubled
debt restructuring has performed according to its modified terms for six months
and the collection of principal and interest under the revised terms is deemed
probable, the Company removes the troubled debt restructuring from impaired
status. When the loan has performed according to its modified terms for one
year, it is no longer considered a troubled debt restructuring.  At
December 31, 2009, we had $7.3 million of loans that were classified as troubled
debt restructurings.




Foreclosed
Assets.Foreclosed assets
include assets acquired in settlement of loans, including four single family
residences totaling $901,000, one parcel of land totaling $115,000 and a
combination of repossessed automobile and manufactured home loans totaling
$368,000.  The largest foreclosed property has a book value of
$499,000 as of December 31, 2009. We do not expect to experience a material
loss on any of the foreclosed assets in our possession.




Other Loans of
Concern.   In addition to the non-performing assets set
forth in the table above, as of December 31, 2009, there were 49 loans totaling
$3.7 million with respect to which known information about the possible credit
problems of the borrowers have caused management to have doubts as to the
ability of the borrowers to comply with present loan repayment terms and which
may result in the future inclusion of such items in the non-performing asset
categories.  These loans have been considered individually in
management’s determination of our allowance for loan losses.  The
largest loan relationship of concern at December 31, 2009, totaled $525,000 to
an individual borrower for a loan secured by commercial real
estate.




Classified
Assets.  Federal regulations provide for the classification of
loans and other assets, such as debt and equity securities considered by the OTS
to be of lesser quality, as “substandard,” “doubtful” or “loss.”  An
asset is considered “substandard” if it is inadequately protected by the current
net worth and paying capacity of the obligor or of the collateral pledged, if
any.  “Substandard” assets include those characterized by the
“distinct possibility” that the insured institution will sustain “some loss” if
the deficiencies are not corrected.  Assets classified as “doubtful”
have all of the weaknesses in those classified “substandard,” with the added
characteristic that the weaknesses present make “collection or liquidation in
full,” on the basis of currently existing facts, conditions and values, “highly
questionable and improbable.”  Assets classified as “loss” are those
considered “uncollectible” and of such little value that their continuance as
assets without the establishment of a specific loss reserve is not
warranted.




When we
classify problem assets as either substandard or doubtful, we may establish
specific allowance for loan losses in an amount deemed prudent by
management.  Our determination as to the classification of our assets
and the amount of our valuation allowances is subject to review by the OTS and
the FDIC, which may order the establishment of additional general or specific
loss allowances.




We
regularly review the problem assets in our portfolio to determine whether any
assets require classification in accordance with applicable
regulations.  On the basis of management’s review of our assets, at
December 31, 2009, we had classified $12.1 million of our assets as substandard,
which represented a variety of outstanding loans, non-agency mortgage backed
securities, foreclosed real estate and other repossessed assets. At that date,
we had no assets classified as doubtful, and there were no assets classified as
loss.  This total amount of classified assets represented 47.7% of our
equity capital and 3.6% of our assets at December 31,
2009.  Classified assets totaled $8.3 million, or 31.7% of our equity
capital and 2.6% of our assets at December 31, 2008.  We continued to
make improvements our credit administration procedures during 2009 which has
allowed us to identify the classification of a number of loans earlier in the
process. In addition to our increased focus on credit administration,
deteriorating economic conditions nationwide and in the markets where we do
business also contributed to the increase in classified assets from 2008 to
2009.





17







Allowance for
Loan Losses.  We maintain an allowance for loan losses to
absorb probable credit losses in the loan portfolio.  The allowance is
based on ongoing, monthly assessments of the estimated probable incurred losses
in the loan portfolio.  In evaluating the level of the allowance for
loan losses, management considers the types of loans and the amount of loans in
the loan portfolio, peer group information, historical loss experience, adverse
situations that may affect the borrower’s ability to repay, estimated value of
any underlying collateral, and prevailing economic conditions.  Large
groups of smaller balance homogeneous loans, such as residential real estate,
small commercial real estate, home equity and consumer loans, are evaluated in
the aggregate using historical loss factors and peer group data adjusted for
current economic conditions.  More complex loans, such as commercial
real estate loans and commercial business loans, are evaluated individually for
impairment, primarily through the evaluation of net operating income and
available cash flow and their possible impact on collateral values.




At
December 31, 2009, our allowance for loan losses was $3.5 million, or 1.18%, of
our total loan portfolio.  Our allowance in 2009 was higher than in
2008 and 2007, because of higher net charge-offs, an increase to the overall
portfolio, in particular our commercial real estate loan portfolio, and a
significant decline in the economic environment.  The increase in the
allowance for loan losses was necessary as a result of the increase in the
Company’s charge-off ratio and an increase in the specific valuation for
impaired loans compared to 2008.




Assessing
the allowance for loan losses is inherently subjective as it requires making
material estimates, including the amount and timing of future cash flows
expected to be received on impaired loans that may be susceptible to significant
change.  In the opinion of management, the allowance, when taken as a
whole, reflects estimated probable loan losses in our loan
portfolio.  See Notes 1 and 5 of the Notes to Consolidated Financial
Statements.





18







The
following table sets forth an analysis of our allowance for loan
losses:




December
      31,2009
            
            
            2008
            
            
            2007
            
            
            2006
            
            
            2005(Dollars
      in thousands)Balance
      at beginning of period
            
            $
            1,306
            
            
            $
            828
            
            
            $
            822
            
            
            $
            1,321
            
            
            $
            1,033Charge-offs:One-to
      four-family
            
            
            104
            
            
            
            114
            
            
            
            -
            
            
            
            -
            
            
            
            -Home
      equity
            
            
            1,368
            
            
            
            62
            
            
            
            -
            
            
            
            -
            
            
            
            -Commercial
      real estate
            
            
            74
            
            
            
            37
            
            
            
            -
            
            
            
            -
            
            
            
            -Commercial
      business
            
            
            149
            
            
            
            71
            
            
            
            -
            
            
            
            -
            
            
            
            -Consumer
            
            
            577
            
            
            
            507
            
            
            
            483
            
            
            
            1,013
            
            
            
            752Total
      charge-offs
            
            
            2,272
            
            
            
            791
            
            
            
            483
            
            
            
            1,013
            
            
            
            752Recoveries:One-to
      four-family
            
            
            -
            
            
            
            2
            
            
            
            -
            
            
            
            -
            
            
            
            -Commercial
      real estate
            
            
            22
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Commercial
      business
            
            
            9
            
            
            
            15
            
            
            
            -
            
            
            
            -
            
            
            
            -Consumer
            
            
            128
            
            
            
            142
            
            
            
            239
            
            
            
            233
            
            
            
            94Total
      recoveries
            
            
            159
            
            
            
            157
            
            
            
            239
            
            
            
            233
            
            
            
            94Net
      charge-offs
            
            
            2,113
            
            
            
            632
            
            
            
            244
            
            
            
            780
            
            
            
            658Additions
      charged to operations
            
            
            4,275
            
            
            
            1,110
            
            
            
            250
            
            
            
            281
            
            
            
            946Balance
      at end of period
            
            $
            3,468
            
            
            $
            1,306
            
            
            $
            828
            
            
            $
            822
            
            
            $
            1,321Net
      charge-offs during the period as a percentage of
              average
      loans outstanding during the period
            
            
            0.75
            %
            
            
            0.26
            %
            
            
            0.11
            %
            
            
            0.40
            %
            
            
            0.37
            %Net
      charge-offs during the period as a percentage of
              average
      non-performing assets
            
            
            50.02
            %
            
            
            144.46
            %
            
            
            33.46
            %
            
            
            184.42
            %
            
            
            262.67
            %Allowance
      as a percentage of
              Non-performing
      loans
            
            
            96.15
            %
            
            
            104.31
            %
            
            
            198.22
            %
            
            
            281.51
            %
            
            
            294.21
            %Allowance
      as a percentage of total loans
              (end
      of period)
            
            
            1.18
            %
            
            
            0.49
            %
            
            
            0.37
            %
            
            
            0.40
            %
            
            
            0.69
            %




The
increase in net charge-offs as a percentage of average non-performing assets is
due to higher net charge-offs during the period specifically related to one- to
four-family loans, home equity loans and commercial real estate and business
loans.  These increases were due to deteriorating market conditions,
specifically related to the housing market in the Puget Sound area and Clallam
County, Washington.




The
increase in our allowance for loan losses as a percentage of non-performing
loans is a result of the increase in non-performing loans during the
period.  The allowance for loan losses as a percentage of total loans
increased to 1.18% as of December 31, 2009 compared to 0.49% as of December 31,
2008.




During
June 2006, we sold our credit card portfolio.  The credit card
portfolio, and charge-offs and the inherent risks associated with that
portfolio, were the primary reasons for the level of provisions taken during the
years December 31, 2005 and 2006.  Net charge-offs for the credit card
portfolio totaled $509,000 in 2006 and $495,000 in 2005.





19







The
distribution of our allowance for losses on loans at the dates indicated is
summarized as follows:




2009
            
            
            2008
            
            2007
            
            
            2006
            
            2005Amount
            
            Percent
              of
      loans
              in
      each
              category
              to
      total
              loans
            
            
            Amount
            
            Percent
              of
      loans
              in
      each
              category
              to
      total
              loans
            
            
            Amount
            
            
            Percent
              of
      loans
              in
      each
              category
              to
      total
              loans
            
            
            Amount
            
            Percent
              of
      loans
              in
      each
              category
              to
      total
              loans
            
            Amount
            
            Percent
              of
      loans
              in
      each
              category
              to
      total
              loansAllocated
      at end of period to:One-
      to four-family
            
            $
            403
            
            36.63
            %
            
            $
            321
            
            
            34.33
            %
            
            $
            145
            
            
            
            38.37
            %
            
            $
            100
            
            41.60
            %
            $
            90
            
            39.84
            %Home
      equity
            
            
            2,252
            
            17.22
            
            
            
            240
            
            
            20.61
            
            
            
            100
            
            
            
            20.53
            
            
            
            40
            
            18.99
            
            
            35
            
            14.86Commercial
      real estate
            
            
            220
            
            24.58
            
            
            
            153
            
            
            18.41
            
            
            
            170
            
            
            
            11.32
            
            
            
            170
            
            8.46
            
            
            165
            
            8.10Construction
      or development
            
            
            -
            
            3.41
            
            
            
            55
            
            
            4.62
            
            
            
            25
            
            
            
            3.90
            
            
            
            30
            
            4.57
            
            
            20
            
            4.05Consumer(1)
            
            
            243
            
            12.09
            
            
            
            379
            
            
            15.36
            
            
            
            298
            
            
            
            20.99
            
            
            
            407
            
            22.71
            
            
            931
            
            27.84Commercial
      business
            
            
            164
            
            6.07
            
            
            
            158
            
            
            6.67
            
            
            
            90
            
            
            
            4.89
            
            
            
            75
            
            3.67
            
            
            80
            
            5.82Total
            
            $
            3,468
            
            100.00
            %
            
            $
            1,306
            
            
            100.00
            %
            
            $
            828
            
            
            
            100.00
            %
            
            $
            822
            
            100.00
            %
            $
            1,321
            
            100.00
            %


___________________________________


(1)
            Because
      of the sale of our credit card portfolio in June 2006, no portion of our
      allowance at December 31, 2009, 2008, 2007 or 2006 was allocated to credit
      card lending.  The allowance for loan losses attributable to our
      credit card portfolio at December 31, 2005
  $600,000.





Investment
Activities




Federal
savings banks have the authority to invest in various types of liquid assets,
including United States Treasury obligations, securities of various federal
agencies, including callable agency securities, certain certificates of deposit
of insured banks and savings institutions, certain bankers’ acceptances,
repurchase agreements and federal funds.  Subject to various
restrictions, federal savings banks may also invest their assets in investment
grade commercial paper and corporate debt securities and mutual funds whose
assets conform to the investments that the institution is otherwise authorized
to make directly.  See “How We Are Regulated – Sound Community Bank –
Office of Thrift Supervision Regulation” for a discussion of additional
restrictions on our investment activities.




Our Chief
Executive Officer and Chief Financial Officer have the responsibility for the
management of our investment portfolio, subject to the direction and guidance of
the Board of Directors.  These officers consider various factors when
making decisions, including the marketability, maturity and tax consequences of
the proposed investment.  The maturity structure of investments will
be affected by various market conditions, including the current and anticipated
slope of the yield curve, the level of interest rates, the trend of new deposit
inflows, and the anticipated demand for funds via deposit withdrawals and loan
originations and purchases.




The
general objectives of our investment portfolio will be to provide liquidity when
loan demand is high, to assist in maintaining earnings when loan demand is low
and to maximize earnings while satisfactorily managing risk, including credit
risk, reinvestment risk, liquidity risk and interest rate risk.  Our
investment quality will emphasize safer investments with the yield on those
investments secondary to not taking unnecessary risk with the available funds of
Sound Community Bank.  See “Management’s Discussion and Analysis of
Financial Condition and Results of Operations – Asset/Liability
Management.”





20







We intend
that the investment strategy and portfolio of Sound Financial will be similar to
that of Sound Community Bank; although Sound Financial will be subject to fewer
regulatory limits than Sound Community Bank in its investments.  We
invested the net proceeds available in our stock offering, after making our
charitable donation and the loan to the employer stock ownership plan, in
deposits in Sound Community Bank.




At
December 31, 2009, we owned $2.4 million in Federal Home Loan Bank of Seattle
stock.  For the year ended December 31, 2009, we received no
dividends from the Federal Home Loan Bank of Seattle.  We are required
to own this stock to be a member of and to obtain advances from our Federal Home
Loan Bank.  This stock is not marketable and can only be redeemed by
our Federal Home Loan Bank.  The Federal Home Loan Bank of Seattle has
reported a risk-based capital deficiency under the regulations of the Federal
Housing Finance Authority, its primary regulator since the end of
2008.  As a result, the Federal Home Loan Bank has suspended dividends
on and the repurchase or redemption of its outstanding common
stock.  The Federal Home Loan Bank has disclosed that it believes the
calculation of risk-based capital under the regulations significantly overstates
the market risk of its private-label mortgage-backed securities in the current
market environment and that it has enough capital to cover the risks reflected
in its balance sheet.  As a result, we have not recorded any
impairment on our Federal Home Loan Bank stock.  However, continued
deterioration in the Federal Home Loan Bank’s financial position may result in
impairment in the value of those securities resulting in a decrease in our
earnings and assets.  Our Federal Home Loan Bank’s financial condition
is linked, in part, to the eleven other members of the Federal Home Loan Bank
System and to accounting rules and asset quality risks that could materially
lower their capital, which would cause our Federal Home Loan Bank stock to be
deemed impaired.




The
following table sets forth the composition of our securities portfolio and other
investments at the dates indicated.  At December 31, 2009, our
securities portfolio did not contain securities of any issuer with an aggregate
book value in excess of 10% of our equity capital, excluding those issued by the
United States Government or its agencies.




December
      31,2009
            
            
            2008
            
            
            2007
            
            
            2006Amortized
              Cost
            
            
            Fair
              Value
            
            
            Amortized
              Cost
            
            
            Fair
              Value
            
            
            Amortized
              Cost
            
            
            Fair
              Value
            
            
            Amortized
              Cost
            
            
            Fair
              Value(In
      thousands)Securities
      available for saleFederal
      agency mortgage-backed
            
            $
            3,421
            
            
            $
            3,370
            
            
            $
            2,007
            
            
            $
            2,029
            
            
            $
            68
            
            
            $
            71
            
            
            $
            165
            
            
            $
            170Non-agency
      mortgage-backed(1)
            
            
            7,901
            
            
            
            6,529
            
            
            
            8,124
            
            
            
            6,901
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---Total
      available for sale
            
            
            11,322
            
            
            
            9,899
            
            
            
            10,131
            
            
            
            8,930
            
            
            
            68
            
            
            
            71
            
            
            
            165
            
            
            
            170Federal
      Home Loan Bank stock
            
            
            2,444
            
            
            
            2,444
            
            
            
            2,444
            
            
            
            2,444
            
            
            
            1,320
            
            
            
            1,320
            
            
            
            1,320
            
            
            
            1,320Total
      securities
            
            $
            13,766
            
            
            $
            12,343
            
            
            $
            12,575
            
            
            $
            11,374
            
            
            $
            1,388
            
            
            $
            1,391
            
            
            $
            1,485
            
            
            $
            1,490


_________________


(1)
            The
      non-agency mortgage backed securities have an unrealized loss of $1.5
      million as of December 31, 2009.  These securities were
      purchased at a discount in 2008 and 2009.  Each of these
      securities has performed and paid principal and interest each month as
      contractually committed.







The
composition and maturities of our investment securities portfolio at December
31, 2009, excluding Federal Home Loan Bank stock, are as
follows  Federal agency mortgage-backed securities with an amortized
cost of $3.4 million and a fair value of $3.4 million and a final maturity
greater than ten years and Non-agency mortgage backed securities with an
amortized cost of $7.9 million and a fair value of $6.5 million and a final
maturity greater than ten years.







21






We review
investment securities on an ongoing basis for the presence of
other-than-temporary (“OTTI”) or permanent impairment, taking into consideration
current market conditions, fair value in relationship to cost, extent and nature
of the change in fair value, issuer rating changes and trends, whether we intend
to sell a security or if it is likely that we will be required to sell the
security before recovery of our amortized cost basis of the investment, which
may be maturity, and other factors.  For debt securities, if we intend
to sell the security or it is likely that we will be required to sell the
security before recovering its cost basis, the entire impairment loss would be
recognized in earnings as an OTTI.  If we do not intend to sell the
security and it is not likely that we will be required to sell the security but
we do not expect to recover the entire amortized cost basis of the security,
only the portion of the impairment loss representing credit losses would be
recognized in earnings.  The credit loss on a security is measured as
the difference between the amortized cost basis and the present value of the
cash flows expected to be collected.





Projected
cash flows are discounted by the original or current effective interest rate
depending on the nature of the security being measured for potential
OTTI.  The remaining impairment related to all other factors, the
difference between the present value of the cash flows expected to be collected
and the fair value, is recognized as a charge to other comprehensive income
(“OCI”).  Impairment losses related to all other factors are presented
as separate categories within OCI.





During
the year ended December 31, 2009, we recognized a $61,000 non-cash other than
temporary impairment (“OTTI”) charge on certain non-agency mortgage-backed
securities included in our portfolio of securities available for sale. 
During the year ended December 31, 2009, we recognized a $61,000 non-cash other
than temporary impairment (“OTTI”) charge on two non-agency mortgage-backed
securities.  At December 31, 2009, the fair value of these two securities
were $1.3 million.  Management concluded that the decline of the estimated
fair value below the cost of the securities was other than temporary and
recorded a credit loss of $61,000 through non-interest income.  We
determined the remaining decline in value of $440,000 was not related to
specific credit deterioration.  We do not intend to sell these securities
and it is more likely than not that we will be required to sell the securities
before anticipated recovery of the remaining amortized cost basis.  We
closely monitor our investment securities for changes in credit risk.  The
current market environment significantly limits our ability to mitigate our
exposure to valuation changes in these securities by selling them. 
Accordingly, if market conditions deteriorate further and we determine our
holdings of these or other investment securities are OTTI, our future earnings,
shareholders’ equity, regulatory capital and continuing operations could be
materially adversely affected.







Sources
of Funds




General.  Our
sources of funds are primarily deposits, borrowings, payments of principal and
interest on loans and funds provided from operations.




Deposits.  We offer a
variety of deposit accounts to both consumers and businesses having a wide range
of interest rates and terms.  Our deposits consist of savings
accounts, money market deposit accounts, demand accounts and certificates of
deposit.  We solicit deposits primarily in our market areas; however,
at December 31, 2009, approximately 4.4% of our deposits were from persons
outside the State of
Washington.As of
December 31, 2009, core deposits, which we define as our non-certificate or
non-time deposit accounts, represented approximately 52.9% of total deposits,
compared to 44.3% as of December 31, 2008.  We primarily rely on
competitive pricing policies, marketing and customer service to attract and
retain these deposits and we expect to continue these practices in the
future.






22






The flow
of deposits is influenced significantly by general economic conditions, changes
in money market and prevailing interest rates and competition.  The
variety of deposit accounts we offer has allowed us to be competitive in
obtaining funds and to respond with flexibility to changes in consumer
demand.  We have become more susceptible to short-term fluctuations in
deposit flows as customers have become more interest rate
conscious.  We manage the pricing of our deposits in keeping with our
asset/liability management, liquidity and profitability objectives, subject to
competitive factors.  Based on our experience, we believe that our
deposits are relatively stable sources of funds.  Despite this
stability, our ability to attract and maintain these deposits and the rates paid
on them has been and will continue to be significantly affected by market
conditions.




The
following table sets forth our deposit flows during the periods
indicated.




For
      the year ended December 31,2009
            
            2008
            
            
            2007(Dollars
      in thousands)Opening
      balance
            $
            222,760
            
            $
            202,791
            
            
            $
            180,968Net
      deposits (withdrawals)
            
            58,681
            
            
            13,529
            
            
            
            15,245Interest
      credited
            
            6,123
            
            
            6,440
            
            
            
            6,578Ending
      balance
            $
            287,564
            
            $
            222,760
            
            
            $
            202,791Net
      increase
            $
            64,804
            
            $
            19,969
            
            
            $
            21,823Percent
      increase
            
            29.2
            %
            
            9.8
            %
            
            
            12.1
            %








23





The
following table sets forth the dollar amount of savings deposits in the various
types of deposit programs offered by Sound Community Bank at the dates
indicated:





December
      31,2009
            
            
            2008
            
            
            2007Amount
            
            
            Percent
              of
      total
            
            
            Amount
            
            
            Percent
              of
      total
            
            
            Amount
            
            
            Percent
              of
      total(Dollars
      in thousands)Transactions
      and Savings Deposits:Interest-bearing
      demand
            
            $
            28,197
            
            
            
            9.81
            %
            
            $
            20,637
            
            
            
            9.30
            %
            
            $
            31,999
            
            
            
            15.78
            %Non
      interest-bearing checking
            
            
            21,227
            
            
            
            7.33
            
            
            
            12,589
            
            
            
            5.67
            
            
            
            13,290
            
            
            
            6.55Statement
      savings
            
            
            20,632
            
            
            
            7.23
            
            
            
            13,109
            
            
            
            5.64
            
            
            
            11,696
            
            
            
            5.77Money
      market
            
            
            81,620
            
            
            
            28.38
            
            
            
            51,744
            
            
            
            23.31
            
            
            
            39,754
            
            
            
            19.60Total
      non-certificates
            
            
            151,676
            
            
            
            52.75
            
            
            
            98,079
            
            
            
            43.92
            
            
            
            96,739
            
            
            
            47.70Certificates:Below
      1%
            
            
            7,189
            
            
            
            2.50
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---1.00
      - 3.99%
            
            
            95,696
            
            
            
            33.28
            
            
            
            41,169
            
            
            
            18.46
            
            
            
            6,339
            
            
            
            3.134.00
      - 5.99%
            
            
            32,992
            
            
            
            11.47
            
            
            
            83,507
            
            
            
            37.62
            
            
            
            99,708
            
            
            
            49.176.00
      - 7.99%
            
            
            12
            
            
            
            0.00
            
            
            
            5
            
            
            
            0.00
            
            
            
            5
            
            
            
            0.00Total
      certificates
            
            
            135,888
            
            
            
            47.25
            
            
            
            124,681
            
            
            
            56.08
            
            
            
            106,052
            
            
            
            52.30Total
      deposits
            
            $
            287,564
            
            
            
            100.00
            %
            
            $
            222,760
            
            
            
            100.00
            %
            
            $
            202,791
            
            
            
            100.00
            %




Recent increases in certificate
accounts reflect the acquisition of deposits from other financial institutions,
as well as the increase in FDIC insurance limits. In addition, we acquired
additional certificate accounts in the 1stSecurity Bank of Washington branch
transaction.  Money market accounts also have increased and interest
bearing demand deposits have decreased as a result of our position in the market
for those accounts. Our plans for 2010 are to continue to attract money market
savings and demand or checking accounts.  We require our commercial
loan customers to maintain a checking or savings account with us.  As
our commercial lending business increases, we anticipate increases in
transaction and savings deposits from our commercial customers.  We
are a public funds depository and as of December 31, 2009, we have approximately
$13.2 million in public funds.  These funds consist of $6.9 million in
certificates of deposit and $6.3 million in money market
accounts.  These accounts are required to be 100%
collateralized.  We use agency mortgage backed securities and letters
of credit from the Federal Home Loan Bank of Seattle as collateral for these
funds.





24







The following table shows rate and
maturity information for the Company’s certificates of deposit at
December 31, 2009.




0.00-
              3.99%
            
            
            
            4.00-
              5.99%
            
            
            Total
            
            
            Percent
              of
      Total(Dollars
      in thousands)Certificate
      accounts
              maturing
      in quarter ending:March
      31, 2010
            
            $
            29,502
            
            
            $
            5,641
            
            
            $
            35,143
            
            
            
            25.86
            %June
      30, 2010
            
            
            12,815
            
            
            
            1,872
            
            
            
            14,686
            
            
            
            10.81September
      30, 2010
            
            
            3,804
            
            
            
            1,262
            
            
            
            5,066
            
            
            
            3.73December
      31, 2010
            
            
            20,418
            
            
            
            13,311
            
            
            
            33,730
            
            
            
            24.82March
      31, 2011
            
            
            24,388
            
            
            
            4,597
            
            
            
            28,985
            
            
            
            21.33June
      30, 2011
            
            
            7,349
            
            
            
            109
            
            
            
            7,458
            
            
            
            5.49September
      30, 2011
            
            
            656
            
            
            
            13
            
            
            
            669
            
            
            
            0.49December
      31, 2011
            
            
            956
            
            
            
            209
            
            
            
            1,165
            
            
            
            0.86March
      31, 2012
            
            
            435
            
            
            
            916
            
            
            
            1,351
            
            
            
            0.99June
      30, 2012
            
            
            217
            
            
            
            388
            
            
            
            605
            
            
            
            0.45September
      30, 2012
            
            
            89
            
            
            
            648
            
            
            
            736
            
            
            
            0.54December
      31, 2012
            
            
            148
            
            
            
            713
            
            
            
            862
            
            
            
            0.63Thereafter
            
            
            2,108
            
            
            
            3,324
            
            
            
            5,432
            
            
            
            4.00Total
            
            $
            102,885
            
            
            $
            33,003
            
            
            $
            135,888
            
            
            
            100.00
            %Percent
      of total
            
            
            75.71
            %
            
            
            24.29
            %
            
            
            100.00
            %




The
following table indicates the amount of our certificates of deposit and other
deposits by time remaining until maturity as of December 31, 2009.




Maturity3
      months or less
            
            
            Over
      3 to 6 months
            
            
            Over
      6 to 12 months
            
            
            Over
      12 months
            
            
            Total(Dollars
      in thousands)Certificates
      of deposit less than $100,000
            
            $
            15,616
            
            
            $
            8,074
            
            
            $
            19,521
            
            
            $
            25,569
            
            
            $
            68,780Certificates
      of deposit of $100,000 or more
            
            
            19,527
            
            
            
            6,612
            
            
            
            19,275
            
            
            
            21,694
            
            
            
            67,108Total
      certificates of deposit
            
            $
            35,143
            
            
            $
            14,686
            
            
            $
            38,796
            
            
            $
            47,263
            
            
            $
            135,888




Borrowings.  Although deposits
are our primary source of funds, we may utilize borrowings as a cost-effective
source of funds when they can be invested at a positive interest rate spread,
for additional capacity to fund loan demand, or to meet our asset/liability
management goals.  Our borrowings currently consist of advances from
the Federal Home Loan Bank of Seattle.  See Note 9 of the Notes to
Consolidated Financial Statements.




We are a
member of and obtain advances from the Federal Home Loan Bank of Seattle, which
is part of the Federal Home Loan Bank System.  The twelve regional
Federal Home Loan Banks provide a central credit facility for their member
institutions.  These advances are provided upon the security of
certain of our mortgage loans and mortgage-backed securities.  These
advances may be made pursuant to several different credit programs, each of
which has its own interest rate, range of maturities and call features, and all
long-term advances are required to provide funds for residential home
financing.  The Company has entered into a loan agreement with the
Federal Home Loan Bank of Seattle pursuant to which it may borrow up to
approximately 35% of its assets, secured by a blanket pledge on a portion of our
residential mortgage portfolio.  At December 31, 2009, we had $20.0
million in Federal Home Loan Bank advances outstanding, which had maturities
between zero and three years, and had the ability to borrow an additional $98.3
million.  At the same date, we had $182.7 million in residential
mortgages, commercial real estate and mortgage-backed securities available to
serve as collateral for additional





25







advances.  We
plan to rely in part on long-term Federal Home Loan Bank advances to fund asset
and loan growth.  We also use short-term advances to meet short term
liquidity needs. We are required to own stock in the Federal Home Loan Bank of
Seattle based on the amount of our advances.




The
following table sets forth the maximum month-end balance and average balance of
borrowings for the periods indicated.




For
      the year ended December 31,2009
            
            
            2008
            
            
            2007(Dollars
      in thousands)Maximum
      balance:Federal
      Home Loan Bank advances
            
            $
            41,950
            
            
            $
            56,119
            
            
            $
            34,519Average
      balances:Federal
      Home Loan Bank advances
            
            $
            28,364
            
            
            $
            38,474
            
            
            $
            26,511Weighted
      average interest rate:Federal
      Home Loan Bank advances
            
            
            3.29
            %
            
            
            3.31
            %
            
            
            5.08
            %




The
following table sets forth certain information about our borrowings at the dates
indicated.





December
      31,2009
            
            
            2008
            
            
            2007(Dollars
      in thousands)Federal
      Home Loan Bank advances
            
            $
            20,000
            
            
            $
            42,219
            
            
            $
            15,869Weighted average interest
      rate:Federal
      Home Loan Bank advances
            
            
            3.27
            %
            
            
            2.73
            %
            
            
            4.63
            %




The
Company is authorized to borrow from the Federal Reserve Bank of San Francisco’s
“discount window” after it has exhausted other reasonable alternative sources of
funds, including Federal Home Loan Bank borrowings.  During 2009, we
borrowed from the Federal Reserve Bank discount window.  The maximum
balance was $8.0 million, the average balance was $1.1 million and the weighted
average rate was 0.50%.  We did not borrow from the Federal Reserve
Bank in 2008 or 2007.




Subsidiary
and Other Activities




The
Company has one inactive subsidiary, which was formed when we were a credit
union to enable us to originate mortgages for nonmembers.  Our capital
investment in the inactive subsidiary as of December 31, 2009 was
$2,000.




Competition




We face
strong competition in attracting deposits and originating
loans.  Competition in originating real estate loans comes primarily
from other savings institutions, commercial banks, credit unions, life insurance
companies and mortgage brokers.  Other savings institutions,
commercial banks, credit unions and finance companies provide vigorous
competition in consumer lending.  Commercial business competition is
primarily from local commercial banks, but other savings banks and credit unions
also compete for this business.  We compete by consistently delivering
high-quality, personal service to our customers which results in a high level of
customer satisfaction.




Our
market area has a high concentration of financial institutions, many of which
are branches of large money center and regional banks that have resulted from
the consolidation of the Companying industry
in Washington and other western states.  These include such large
national lenders as US Bank,








26








JP Morgan
Chase, Wells Fargo, Bank of America, Key Bank and others in our market area that
have greater resources than we do and offer services that we do not
provide.  For example, we do not offer trust services or non-FDIC
insured investments.  Customers who seek “one-stop shopping” may be
drawn to institutions that offer services that we do not.




We
attract our deposits through our branch office system.  Competition
for those deposits is principally from other savings institutions, commercial
banks and credit unions located in the same community, as well as mutual funds
and other alternative investments.  We compete for these deposits by
offering superior service and a variety of deposit accounts at competitive
rates.  Based on the most recent data provided by the FDIC, there are
approximately 75 other commercial banks and savings institutions operating in
the Seattle-Tacoma-Bellevue, Washington Metropolitan Statistical Area and 13
other commercial banks and savings institutions in Clallam
County.  Based on the most recent branch deposit data provided by the
FDIC, the Company’s share of deposits in the Seattle-Tacoma-Bellevue, Washington
Metropolitan Statistical Area was approximately 0.2%.  The five
largest financial institutions in that area have 69.1% of those
deposits.  In addition, our share of deposits in Clallam County was
8.2%, with the five largest institutions in that county having 67.1% of the
deposits.




Employees




At
December 31, 2009, we had a total of 78 full-time employees and 11 part-time
employees.  Our employees are not represented by any collective
bargaining group. Management considers its employee relations to be
good.




How
We Are Regulated




Set forth
below is a brief description of certain laws and regulations that are applicable
to the Company, the Bank and the MHC.  The description of these laws
and regulations, as well as descriptions of laws and regulations contained
elsewhere herein, does not purport to be complete and is qualified in its
entirety by reference to the applicable laws and regulations.




Legislation
is introduced from time to time in the United States Congress that may affect
our operations.  In addition, the regulations governing the Company,
the Bank and the MHC may be amended from time to time by the FDIC or the
OTS.  Any such legislative or regulatory changes in the future could
adversely affect our operations and financial condition.  No assurance
can be given as to whether or in what form any such changes may
occur.




The OTS
has extensive enforcement authority over all savings associations and their
holding companies, including the Company, the Bank and the MHC.  This
enforcement authority includes, among other things, the ability to assess civil
money penalties, to issue cease-and-desist or removal orders and to initiate
injunctive actions.  In general, these enforcement actions may be
initiated for violations of laws and regulations and unsafe or unsound
practices.  Other actions or inactions may provide the basis for
enforcement action, including misleading or untimely reports filed with the
OTS.  Except under certain circumstances, public disclosure of formal
enforcement actions by the OTS is required by law.




Congress
is currently considering significant regulatory reform legislation initially
proposed by the Obama administration.  This legislation, if enacted,
could have a significant impact on the regulation and operations of financial
institutions and their holding companies.  It currently provides for
the elimination of the OTS, our primary regulator, and would require the Company
and the MHC to become bank holding companies and be subject to regulatory
capital requirements for the first time.  This





27







elimination
of OTS may require the Company to convert to a national bank or a state bank
charter.  This legislation also provides for the creation of a new
consumer financial protection agency that would issue and enforce consumer
protection initiatives governing financial products and services.  The
details and impact of this regulatory reform proposal cannot be determined until
the proposal is enacted into law.





Sound Community
Bank




The
Company, as a federally chartered savings bank, is subject to regulation and
oversight by the OTS, which extends to all aspects of its
operations.  This regulation of the Company is intended for the
protection of depositors and the insurance of accounts fund and not for the
purpose of protecting shareholders.  The Company is required to
maintain minimum levels of regulatory capital and is subject to some limitations
on the payment of dividends to Sound Financial.  See “- Regulatory
Capital Requirements” and “- Limitations on Dividends and Other Capital
Distributions.”  The Company also is subject to regulation and
examination by the FDIC, which insures the deposits of the Company to the
maximum extent permitted by law.




Office of Thrift
Supervision.  The investment and lending authority of the
Company is prescribed by federal laws and regulations, and it is prohibited from
engaging in any activities not permitted by such laws and
regulations.




As a
federal savings bank, the Company is required to meet a qualified thrift lender
test.  This test requires the Company to have at least 65% of its
portfolio assets, as defined by regulation, in qualified thrift investments on a
monthly average for nine out of every 12 months on a rolling
basis.  As an alternative, we may maintain 60% of our assets in those
assets specified in Section 7701(a)(19) of the Internal Revenue
Code.  Under either test, we are required to maintain a significant
portion of our assets in residential housing-related loans and
investments.  Any institution that fails to meet the qualified thrift
lender test becomes subject to certain restrictions on its operations and must
convert to a national bank charter, unless it re-qualifies as, and thereafter
remains, a qualified thrift lender.  If such an institution has not
requalified or converted to a national bank within three years after the
failure, it must divest of all investments and cease all activities not
permissible for a national bank.  As of December 31, 2009, the Company
met this requirement with a qualified thrift lender percentage of
80.3%.




Our
relationship with our depositors and borrowers is regulated to a great extent by
federal laws and regulations, especially in such matters as the ownership of
accounts and the form and content of our mortgage requirements.  In
addition, the branching authority of the Company is regulated by the
OTS.  The Company is generally authorized to branch
nationwide.




The
Company is subject to a statutory lending limit for aggregate loans to one
person or a group of persons combined because of certain common
interests.  That limit is equal to 15% of our unimpaired capital and
surplus, except for loans fully secured by readily marketable collateral, in
which case that limit is increased to 25%.  At December 31, 2009, the
Company’s lending limit under this restriction was $4.3 million. We have no
loans or lending relationships in excess of our lending limit.




We are
subject to periodic examinations by the OTS.  During these
examinations, the examiners may require the Company to provide for higher
general or specific loan loss reserves, which can impact our capital and
earnings.  As a federal savings bank, the Company is subject to a
semi-annual assessment, based upon its total assets, to fund the operations of
the OTS.




Transactions
between the Company and its affiliates generally are required to be on terms as
favorable to the institution as transactions with non-affiliates, and certain of
these transactions, such as loans to an affiliate, are restricted to a
percentage of the Company’s capital.  In addition, the Company may not
lend to any affiliate engaged in activities not permissible for a bank holding
Company or acquire the securities of most affiliates.  Sound Financial
and MHC are affiliates of the Company.






28






The OTS
has adopted guidelines establishing safety and soundness standards on such
matters as loan underwriting and documentation, asset quality, earnings
standards, internal controls and audit systems, interest rate risk exposure and
compensation and other employee benefits.  Any institution regulated
by the OTS that fails to comply with these standards must submit a compliance
plan.




FDIC Regulation
and Insurance of Accounts.  The Company’s deposits are insured
up to the applicable limits by the FDIC, and such insurance is backed by the
full faith and credit of the United States Government.  As insurer,
the FDIC imposes deposit insurance premiums and is authorized to conduct
examinations of and to require reporting by FDIC-insured
institutions.  Our deposit insurance premiums for the year ended
December 31, 2009 were $506,000.  Those premiums will increase in 2010
due to strains on the FDIC deposit insurance fund due to the cost of large bank
failures and increase in the number of troubled banks.




The
Company is a member of the deposit insurance fund administered by the
FDIC.  Deposits are insured up to the applicable limits by the
FDIC.  Through December 31, 2013, the basic deposit insurance is
$250,000, instead of the $100,000 limit that had been in effect prior to October
2008.  The FDIC also provides unlimited deposit insurance coverage for
noninterest-bearing transaction accounts (typically business checking accounts),
NOW accounts bearing interest at 0.5% or less, and certain funds swept into
noninterest-bearing savings accounts at institutions that opt into this enhanced
deposit insurance coverage.  The Company opted into this program,
which is set to expire on June 30, 2010.  The Company paid a fee of 10
basis points (annualized) on the balance of each covered account in excess of
$250,000, which totaled $1,000 for the year ended December 31,
2009.  After expiration, the fee for this program will be 15 - 25
basis points based on the Company’s risk category for deposit insurance premium
levels.




The FDIC
assesses deposit insurance premiums quarterly on each FDIC-insured institution
based on annualized rates for one of four risk categories applied to its
deposits subject to certain adjustments.  Each institution is assigned
to one of four risk categories based on its capital, supervisory ratings and
other factors.  Well capitalized institutions that are financially
sound with only a few minor weaknesses are assigned to Risk Category
I.  Risk Categories II, III and IV present progressively greater risks
to the deposit insurance fund.  Under the FDIC’s risk-based assessment
rules, effective April 1, 2009, the initial base assessment rates prior to
adjustments range from 12 to 16 basis points for Risk Category I, and are 22
basis points for Risk Category II, 32 basis points for Risk Category III, and 45
basis points for Risk Category IV.  Initial base assessment rates are
subject to adjustments based on an institution’s unsecured debt, secured
liabilities and brokered deposits, such that the total base assessment rates
after adjustments range from 7 to 24 basis points for Risk Category I, 17 to 43
basis points for Risk Category II, 27 to 58 basis points for Risk Category III,
and 40 to 77.5 basis points for Risk Category IV.  Rates increase
uniformly by 3 basis points effective January 1, 2011.




In
addition to the regular quarterly assessments, due to losses and projected
losses attributed to failed institutions, the FDIC imposed a special assessment
of 5 basis points on the amount of each depository institution’s assets reduced
by the amount of its Tier 1 capital (not to exceed 10 basis points of its
assessment base for regular quarterly premiums) as of June 30, 2009, which was
collected on September 30, 2009.




As a
result of a decline in the reserve ratio (the ratio of the net worth of the
deposit insurance fund to estimated insured deposits) and concerns about
expected failure costs and available liquid assets in the deposit insurance
fund, the FDIC required each insured institution to prepay on December 30, 2009,
the estimated amount of its quarterly assessments for the fourth quarter of 2009
and all quarters through the end of 2012 (in addition to the regular quarterly
assessment for the third quarter which was due on December 30,
2009).  The prepaid amount is recorded as an asset with a zero risk
weight and the institution will continue to record quarterly expenses for
deposit insurance.  For purposes of calculating








29








the
prepaid amount, assessments are measured at the institution’s assessment rate as
of September 30, 2009, with a uniform increase of 3 basis points effective
January 1, 2011, and are based on the institution’s assessment base for the
third quarter of 2009, with growth assumed quarterly at an annual rate of
5%.  If events cause actual assessments during the prepayment period
to vary from the prepaid amount, institutions will pay excess assessments in
cash, or receive a rebate of prepaid amounts not exhausted after collection of
assessments due on January 13, 2013, as applicable. Collection of the prepayment
does not preclude the FDIC from changing assessment rates or revising the
risk-based assessment system in the future.  The rule includes a
process for exemption from the prepayment for institutions whose safety and
soundness would be affected adversely.




The FDIC
estimates that the reserve ratio will reach the designated reserve ratio of
1.15% by 2017 as required by statute.




The FDIC
also may prohibit any FDIC-insured institution from engaging in any activity
that it determines by regulation or order to pose a serious risk to the deposit
insurance fund.  The FDIC also has the authority to initiate
enforcement actions against the Company and may terminate our deposit insurance
if it determines that we have engaged in unsafe or unsound practices or are in
an unsafe or unsound condition.





Sound Financial and Sound
Community MHC




As
savings association holding companies, Sound Financial and MHC are subject to
regulation, supervision and examination by the OTS.  The terms of
their charters and bylaws are prescribed by the OTS.  Under
regulations of the OTS, MHC must own a majority of outstanding shares of Sound
Financial in order to qualify as a mutual holding Company.  Applicable
federal laws and regulations limit the activities of Sound Financial and MHC and
require the approval of the OTS for any acquisition or divestiture of a
subsidiary, including another financial institution or holding Company
thereof.  Transactions between MHC or Sound Financial and the Company
are subject to regulatory limits and requirement for transactions with
affiliates.




If the
Company fails the qualified thrift lender test, MHC and Sound Financial must
obtain the approval of the OTS prior to continuing, directly or through other
subsidiaries, in any business activity other than those approved for bank
holding companies or their subsidiaries.  In addition, within one year
of such failure, MHC and Sound Financial must register as, and will become
subject to, the restrictions applicable to bank holding companies.




Under
regulations of the OTS, MHC may convert to the stock form of ownership, though
it has no current intention to do so.  In that stock conversion, the
members of MHC would have a right to subscribe for shares of stock in a new
Company that would own MHC’s shares in Sound Financial.  In addition,
each share of stock in Sound Financial not owned by MHC would be converted into
shares in that new Company in an amount that preserves the holder’s percentage
ownership.





Regulatory Capital
Requirements





The Company
is required to maintain minimum levels of regulatory capital under regulations
of the OTS.  In addition, the OTS is also authorized to impose capital
requirements in excess of these standards on a case-by-case
basis.




The
capital regulations require tangible capital of at least 1.5% of adjusted total
assets, as defined by regulation.  At December 31, 2009, the Company
had tangible capital of $25.3 million or 7.46% of adjusted total assets. The
capital standards require core or Tier 1 capital equal to at least 3.0% of
adjusted








30








total
assets for the strongest institutions with the highest examination rating and
4.0% of adjusted total assets for all other institutions, unless the OTS
requires a higher level based on the particular circumstances or risk profile of
the institution.  Core capital generally consists of tangible capital,
plus certain intangibles.  Our required core capital level is
4%.  At December 31, 2009, the Company had core capital equal to $25.0
million or 7.37% of adjusted total assets. The OTS also requires the Company to
have total capital of at least 8.0% of risk-weighted assets.  Total
capital consists of core or Tier 1 capital, as defined above, and Tier 2
capital, which for the Company, at December 31, 2009, consisted of $3.0 million
of its allowance for possible loan and lease losses. Tier 2 capital may be used
to satisfy this risk-based requirement only to the extent of Tier 1
capital.  In determining the amount of risk-weighted assets, all
assets, including certain off-balance sheet items, will be multiplied by a risk
weight, ranging from 0% to 100%, based on the risk inherent in the type of
asset.  The OTS is authorized to require Sound Community Bank to
maintain an additional amount of total capital to account for concentration of
credit risk, level of interest rate risk, equity investments in non-financial
companies and the risk of non-traditional activities.  At December 31,
2009, the Company had $239.9 million of risk-weighted assets and total capital
of $28.0 million or 11.7% of risk-weighted assets.




The OTS
is authorized and, under certain circumstances, required to take certain actions
against savings banks that fail to meet these capital requirements, or that fail
to maintain an additional capital ratio of Tier 1 capital of at least 4.0% of
risk weighted-assets.  The OTS is generally required to take action to
restrict the activities of an “undercapitalized institution,” which is an
institution with less than either a 4.0% core capital ratio, a 4.0% Tier 1
risked-based capital ratio or an 8.0% total risk-based capital
ratio.  Any such institution must submit a capital restoration plan
and until such plan is approved by the OTS may not increase its assets, acquire
another institution, establish a branch or engage in any new activities, and
generally may not make capital distributions.  The OTS is authorized
to impose the additional restrictions on undercapitalized
institutions.




Any
institution that fails to comply with its capital plan or has Tier 1 risk-based
or core capital ratios of less than 3.0% or a total risk-based capital ratio of
less than 6.0% is considered “significantly undercapitalized” and must be made
subject to one or more additional specified actions and operating restrictions
that may cover all aspects of its operations and may include a forced merger or
acquisition of the institution.  An institution with tangible equity
to total assets of less than 2.0% is “critically undercapitalized” and becomes
subject to further mandatory restrictions on its operations.  The OTS
generally is authorized to reclassify an institution into a lower capital
category and impose the restrictions applicable to such category if the
institution is engaged in unsafe or unsound practices or is in an unsafe or
unsound condition.  The imposition by the OTS of any of these measures
on the Company may have a substantial adverse effect on its operations and
profitability.




Institutions
with at least a 4.0% core capital ratio, a 4.0% Tier 1 risked-based capital
ratio and an 8.0% total risk-based capital ratio are considered
“adequately-capitalized.”  An institution is deemed a
“well-capitalized” institution if it has at least a 5.0% leverage capital ratio,
a 6.0% Tier 1 risked-based capital ratio and a 10.0% total risk-based capital
ratio.  At December 31, 2009, the Company was considered a
“well-capitalized” institution.




The OTS
also is authorized to reclassify an institution into a lower capital category
and impose the restrictions applicable to such category if the institution is
engaged in unsafe or unsound practices or is in an unsafe or unsound
condition.  The imposition by the OTS of any of these measures on the
Company may have a substantial adverse effect on its operations and
profitability.







31









Capital
Requirements for Sound Financial and MHC.




Sound
Financial and MHC are not subject to any specific capital
requirements.  The OTS, however, expects them to support the Company,
including providing additional capital to the Company when it does not meet its
capital requirements.  As a result of this expectation, the OTS
regulates the ability of the Company to pay dividends to Sound
Financial.





Limitations on Dividends and
Other Capital Distributions




OTS
regulations impose various restrictions on savings institutions with respect to
the ability of the Company to make distributions of capital, which include
dividends, stock redemptions or repurchases, cash-out mergers and other
transactions charged to the capital account.  The Company must file a
notice or application with the OTS before making any capital
distribution.  The Company generally may make capital distributions
during any calendar year in an amount up to 100% of net income for the
year-to-date plus retained net income for the two preceding years, so long as it
is well-capitalized after the distribution.  If the Company, however,
proposes to make a capital distribution when it does not meet its current
minimum capital requirements (or will not following the proposed capital
distribution) or that will exceed these net income limitations, it must obtain
OTS approval prior to making such distribution.  The OTS may object to
any distribution based on safety and soundness concerns.




Sound
Financial will not be subject to OTS regulatory restrictions on the payment of
dividends.  Dividends from Sound Financial, however, may depend, in
part, upon its receipt of dividends from the Company.  In addition,
the Company may not make a distribution that would constitute a return of
capital during the three-year term of the business plan submitted in connection
with this mutual holding Company reorganization and stock
issuance.  No insured depositary institution may make a capital
distribution if, after making the distribution, the institution would be
undercapitalized.




MHC may
elect to waive its pro rata portion of a dividend declared and paid by Sound
Financial after filing a notice with and receiving no objection from the
OTS.  We anticipate that MHC, subject to its own need for capital and
funds, will waive dividends paid by Sound Financial.  The interests of
other shareholders of Sound Financial who receive dividends are not diluted by
any waiver of dividends by MHC in the event of a full stock
conversion.




Federal
Taxation




General.  The
Company and the Bank are subject to federal income taxation in the same general
manner as other corporations, with some exceptions discussed
below.  The following discussion of federal taxation is intended only
to summarize certain pertinent federal income tax matters and is not a
comprehensive description of the tax rules applicable to Sound Financial or the
Company.  The Company and the Bank’s federal income tax returns have
never been audited.




The
Company adopted the provisions of FASB ASC Topic 740, Accounting for Uncertainty
in Income Taxes, on January 1, 2007.  The Company had no unrecognized
tax benefits which would require an adjustment to the January 1, 2007 beginning
balance of retained earnings.  The Company had no unrecognized tax
benefits at December 31, 2008 and at December 31, 2009.




The
Company recognizes interest accrued and penalties related to unrecognized tax
benefits in tax expense.  During the years ended December 31, 2009 and
2008 the Company recognized no interest and penalties.






32






The
Company or one of its subsidiaries files income tax returns in the U.S. federal
jurisdiction, and various states.  With few exceptions, the Company is
no longer subject to U.S. federal or state/local income tax examinations by tax
authorities for years before 2004.




Method of
Accounting.  For federal income tax purposes, the Company
currently reports its income and expenses on the accrual method of accounting
and uses a fiscal year ending on December 31 for filing its federal income tax
return.




Minimum
Tax.  The Internal Revenue Code imposes an alternative minimum
tax at a rate of 20% on a base of regular taxable income plus certain tax
preferences, called alternative minimum taxable income.  The
alternative minimum tax is payable to the extent such alternative minimum
taxable income is in excess of the regular tax.  Net operating losses
can offset no more than 90% of alternative minimum taxable
income.  Certain payments of alternative minimum tax may be used as
credits against regular tax liabilities in future years.  The Company
and the Bank has not been subject to the alternative minimum tax, nor do we have
any such amounts available as credits for carryover.




Net Operating
Loss Carryovers.  A financial institution may carryback net
operating losses to the preceding two taxable years and forward to the
succeeding 20 taxable years.  This provision applies to losses
incurred in taxable years beginning after August 6, 1997.  At December
31, 2009, we had no net operating loss carryforwards for federal income tax
purposes.




Corporate
Dividends-Received Deduction.  Sound Financial has elected to
file a consolidated return with the Company.  Therefore any dividends
it receives from the Company will not be included as income to the
Company.  The corporate dividends-received deduction is 100%, or 80%
in the case of dividends received from corporations with which a corporate
recipient does not file a consolidated tax return, depending on the level of
stock ownership of the payer of the dividend.




State
Taxation




The
Company and the Bank are subject to a business and occupation tax imposed under
Washington law at the rate of 1.5% of gross receipts.  Interest
received on loans secured by mortgages or deeds of trust on residential
properties and certain investment securities are exempt from this
tax.




Internet
Website




The
Company and the Bank maintain a website, www.soundcb.com.  Information
pertaining to Sound Financial, Inc, including SEC filings, can be found by
clicking the link on our site called “Investor Relations.” This Annual Report on
Form 10-K and our other reports, proxy statements and other information filed
with the SEC are available on that website within the Investor Relations webpage
by clicking the link called “SEC Filings.”  The information contained
on our website is not included as a part of, or incorporated by reference into,
this Annual Report on Form 10-K.  For more information regarding access to
these filings on our website, please contact our Corporate Secretary, Sound
Financial, Inc., 2005 5th Avenue, Suite 200, Seattle, Washington, 98121 or by
calling (206) 448-0884.




Item
1A.  Risk Factors




Not
required; the Company is a smaller reporting Company




Item
1B.  Unresolved Staff Comments




None






33






Item
2.     Properties




The
following table sets forth certain information concerning the main office and
each branch office of Sound Community Bank at December 31, 2009.  All
of our offices are leased.  The operating leases contain renewal
options and require the Company to pay property taxes and operating expenses on
the properties.  Our total rental expense for each of the years ended
December 31, 2009, 2008 and 2007 was $759,000, $627,000 and $538,000,
respectively. The aggregate net book value of the Company’s leasehold
improvements, furniture and equipment was $3.5 million at December 31, 2009. See
also Note 7 of the Notes to Consolidated Financial Statements.  In the
opinion of management, the facilities are adequate and suitable for the current
needs of Sound Community Bank.  During 2009, we opened one new
branches in Port Angeles, acquired the Tacoma branch of 1st
Security Bank of Washington and consolidated our Lakewood branch into the Tacoma
facility. We will close our East Marginal Way facility on March 31, 2010, when
the current lease is complete.  We may open additional banking offices
after 2010 to better serve current customers and to attract new
customers.







Location
            Year
      opened
            Owned
      or leased
            Lease
      expiration dateMain
      office:2005
      5th Avenue
              Seattle,
      WA 98121
            1993
            Leased
            20171Branch
      offices:Cedar
      Plaza Branch
              22807
      44th Avenue West
              Mountlake
      Terrace, WA 98043
            2004
            Leased
            20152East
      Marginal Branch(Tukwila)
              10200
      East Marginal Way South
              Seattle,
      WA 98168
            1953
            Leased
            20103Lakewood
      Branch
              Lakewood
      Town  Center
              61111
      Lakewood Town Center
              Blvd.,
      SW, Suite B
              Lakewood,
      WA 98499
            2004
            Leased
            20104Tacoma
      Branch
              2941
      S. 38th Street
              Tacoma,
      WA 98409
            2009
            Leased
            2011Sequim
      Branch
              541
      North 5th Avenue
              Sequim,
      WA 98382
            1997
            Leased
            20135Port
      Angeles Branch
              110
      N. Alder Street
              Port
      Angeles, WA 98682
            2010
            Leased
            20286


_________________


1. Lease
contains no renewal option.


2. Lease
provides for four five-year renewals.


3. Lease
provides for one two-year renewal.  The Company plans to close this
branch on March 31, 2010.


4. Lease
provides for one five-year renewal. This branch was consolidated into our Tacoma
Branch during 2009.


5. Lease
provides for two nine-year renewals.


6. Lease
provides for two ten-year renewals.





The
Company also owns a building in Port Angeles that was acquired as a part of the
1st
Security Transaction.  This building was not in use as of December 31,
2009.  Management intends to either lease or sell the building in
2010.






34






We
maintain depositor and borrower customer files on an on-line basis, utilizing a
telecommunications network, portions of which are leased. Management has a
disaster recovery plan in place with respect to the data processing system, as
well as Sound Community Bank’s operations as a whole.




Item
3.    Legal Proceedings




From time
to time we are involved as plaintiff or defendant in various legal actions
arising in the normal course of business.  We do not anticipate
incurring any material legal fees or other liability as a result of such
litigation.




Item
4.    (Removed and Reserved)




PART
II




Item
5.    Market for Registrant’s Common Equity, Related
Stockholder Matters and Issuer Purchases of Equity Securities




The
shares of common stock of Sound Financial are traded on the Over-the-Counter
Electronic Bulletin Board under the symbol "SNFL." The table below shows the
high and low closing prices for our common stock for the periods indicated and
quarterly dividends paid in 2009.  We had no common stock outstanding
as of December 31, 2008. Our minority public offering closed on January 8, 2008
at a price of $10.00 per share, so pricing information is available from that
date forward.  This stock price information was provided by the Yahoo
Finance System and is based on OTC quotations, which reflect inter-dealer prices
with retail mark-up, mark-down or commissions and may not represent actual
transactions, except for January 8, 2008, which reflects the original price in
the stock offering.







Stock
      Price
            
            Dividends
              Per
      Share2009
      Quarters
            High
            LowFirst
      Quarter (1/01/2009 to 3/31/2009)
            $7.50
            $5.90
            
            $0.04Second
      Quarter (4/1/2009 to 6/30/2009)
            $7.00
            $5.75
            
            $0.04Third
      Quarter (7/1/2009 to 9/30/2009)
            $7.00
            $5.45
            
            $0.02Fourth
      Quarter (10/1/2009 to 12/31/2009)
            $6.00
            $4.10
            
            $0.02




Stock
      Price
            
            Dividends
              Per
      Share2008
      Quarters
            High
            LowFirst
      Quarter (1/8/2008 to 3/31/2008)
            $10.00
            $9.00
            
            ---Second
      Quarter (4/1/2008 to 6/30/2008)
            $
      9.24
            $9.10
            
            $0.04Third
      Quarter (7/1/2008 to 9/30/2008)
            $
      9.10
            $7.30
            
            $0.04Fourth
      Quarter (10/1/2008 to 12/31/2008)
            $
      7.50
            $6.05
            
            $0.04




At
December 31, 2009, there were 3,000,095 shares outstanding and the closing price
of our common stock on that date was $4.10.  On that date, we had
approximately 319 shareholders of record.




Our cash
dividend payout policy is reviewed continually by management and the Board of
Directors.  The Company intends to continue its policy of paying
quarterly dividends; however the payment will depend upon a number of factors,
including capital requirements, our financial condition and results of
operations, tax considerations, statutory and regulatory limitations, and
general economic conditions.  No assurances can be given that any
dividends will be paid or that, if paid, will not be reduced or eliminated in
future periods. Our future payment of dividends may depend, in part, upon
receipt of dividends from Sound Community Bank.  Federal regulations
restrict the ability of Sound Community Bank to pay dividends and make other
capital distributions to us.






35






Information
regarding our equity compensation plan is included in Item 12 of this Form
10-K.




On
November 24, 2008, the Company announced that its Board of Directors had
authorized management to repurchase up to 57,782 shares of the Company’s
outstanding stock over a twelve-month period.  The repurchased shares
were to be used to fund the restricted stock portion of our 2008 equity
incentive plan.  The Company repurchased 45,800 shares in
2009.




Information
on the shares repurchased during the quarters ended September 30, 2009 and
December 31, 2009, is as follows:




Total
      Number
              of
      Shares
              Purchased
            
            Average
              Price
      Per
              Share
            
            Total
      Number of
              Shares
      Purchased as Part of  Publicly Announced Plan
            
            Minimum
      Number of
              Shares
      that May Yet
              Be
      Purchased
              Under
      the PlanJuly
      1 to 31, 2009
            -
            
            
            
            -
            
            25,582(1)October
      1 to 31, 2009
            8,500
            
            $5.97
            
            8,500
            
            17,082November
      1 to 30, 2009
            5,100
            
            5.50
            
            5,100
            
            11,982(2)December
      1 to 31, 2009
            -
            
            -
            
            -13,600
            
            $5.79
            
            13,600


____________________


1)
            Amount
      represents the number of shares available to be repurchased under the Plan
      as of the close of business on September 30,
  2009.


2)
            Amount
      represents the number of shares available to be repurchased under the Plan
      as of the close of business on December 31,
  2009.








36





Item
6.    Selected Financial Data





SELECTED
CONSOLIDATED FINANCIAL AND OTHER DATA




The
following information is only a summary and you should read it in conjunction
with our consolidated financial statements and accompanying notes contained in
Item 8 of this Form 10-K.







At
      December 31,2009
            
            
            2008
            
            
            2007(In
      thousands)Selected Financial
      Condition Data:Total
      assets
            
            $
            337,806
            
            
            $
            293,497
            
            
            $
            236,965Loans
      receivable, net
            
            
            286,357
            
            
            
            262,407
            
            
            
            219,406Loans
      held for sale
            
            
            2,858
            
            
            
            956
            
            
            
            822Mortgage-backed
      securities available for sale (at fair value)
            
            
            9,899
            
            
            
            8,930
            
            
            
            71Federal
      Home Loan Bank stock
            
            
            2,444
            
            
            
            2,444
            
            
            
            1,320Deposits
            
            
            287,564
            
            
            
            222,560
            
            
            
            202,791Federal
      Home Loan Bank advances
            
            
            20,000
            
            
            
            42,419
            
            
            
            15,869Equity
            
            
            25,068
            
            
            
            26,103
            
            
            
            15,888




Selected Operations
      Data:
              
              
              2009
              
              
              
              2008
              
              
              
              2007Total
      interest income
              
              $
              19,128
              
              
              $
              16,959
              
              
              $
              14,959Total
      interest expense
              
              
              7,057
              
              
              
              7,713
              
              
              
              7,925Net
      interest income
              
              
              12,071
              
              
              
              9,246
              
              
              
              7,034Provision
      for loan losses
              
              
              4,275
              
              
              
              1,110
              
              
              
              250Net
      interest income after provision for loan losses
              
              
              7,796
              
              
              
              8,136
              
              
              
              6,784Fees
      and service charges
              
              
              2,081
              
              
              
              1,813
              
              
              
              1,633Gain
      (loss) on sales of loans
              
              
              157
              
              
              
              (15)
              
              
              
              11Gain
      on sales of securities
              
              
              273
              
              
              
              154
              
              
              
              ---Loss
      on sales of assets
              
              
              (627
              )
              
              
              ---
              
              
              
              ---Other
      non-interest income
              
              
              1,424
              
              
              
              223
              
              
              
              472Total
      non-interest income
              
              
              3,308
              
              
              
              2,175
              
              
              
              2,116Total
      non-interest expense
              
              
              12,183
              
              
              
              10,004
              
              
              
              8,519Income
      (loss) before provision for income taxes
              
              
              (1,079
              )
              
              
              307
              
              
              
              381Provision
      (benefit) for income taxes
              
              
              (465
              )
              
              
              45
              
              
              
              62Net
      income (loss)
              
              $
              (614
              )
              
              $
              262
              
              
              $
              319
  Selected
      Financial Ratios and Other Data:Performance
      ratios:Return
      on assets (ratio of net income to average total assets)
              
              
              (0.19)
              %
              
              
              0.10
              %
              
              0.14
              %Return
      on equity (ratio of net income to average equity)
              
              
              (2.38)
              %
              
              
              0.98
              %
              
              2.00
              %Interest
      rate spread information:Average
      during period
              
              
              3.98
              %
              
              
              3.50
              %
              
              3.11
              %End
      of period
              
              
              4.53
              %
              
              
              3.54
              %
              
              3.19
              %Net interest
      margin(1)
              
              
              3.99
              %
              
              
              3.62
              %
              
              3.22
              %Non-interest
      income to operating revenue
              
              
              21.51
              %
              
              
              19.04
              %
              
              23.12
              %Operating
      expense to average total assets
              
              
              3.74
              %
              
              
              3.69
              %
              
              3.70
              %Average
      interest-earning assets to average interest-bearing
      liabilities
              
              
              101.78
              %
              
              
              106.33
              %
              
              99.79
              %Efficiency
      ratio(2)
              
              
              79.22
              %
              
              
              87.59
              %
              
              93.10
              %Asset
      quality ratios:Non-performing
      assets to total assets at end of period
              
              
              1.48
              %
              
              
              1.01
              %
              
              0.54
              %Non-performing
      loans to gross loans
              
              
              1.25
              %
              
              
              0.47
              %
              
              0.19
              %Allowance
      for loan losses to non-performing loans
              
              
              91.99
              %
              
              
              104.31
              %
              
              198.22
              %Allowance
      for loan losses to gross loans
              
              
              1.18
              %
              
              
              0.49
              %
              
              0.37
              %Net
      charge-offs to average loans outstanding
              
              
              0.75
              %
              
              
              0.26
              %
              
              0.11
              %Capital
      ratios:Equity
      to total assets at end of period
              
              
              7.42
              %
              
              
              8.89
              %
              
              6.70
              %Average
      equity to average assets
              
              
              7.93
              %
              
              
              9.86
              %
              
              6.94
              %Other
      data:Number
      of full service offices
              
              
              6
              
              
              
              5
              
              
              
              5


_____________________________


(1)
            Net
      interest income divided by average interest earning
  assets.


(2)
            Total
      other operating expense, excluding real estate owned and repossessed
      property expense, as a percentage of net interest income and total other
      operating income, excluding net securities
  transactions.








37





Item
7.  Management’s Discussion and Analysis of Financial Condition and
Results of Operation




MANAGEMENT’S
DISCUSSION AND ANALYSIS OF


FINANCIAL
CONDITION AND RESULTS OF OPERATIONS




General




Sound
Financial was incorporated on January 8, 2008, to hold all of the stock of the
Company, which converted from a state-charted credit union to a federally
chartered savings bank in 2003. Prior to that conversion, the Company operated
as Credit Union of the Pacific.




The
Company’s principal business consists of attracting retail deposits from the
general public and investing those funds, along with borrowed funds, in loans
secured by first and second mortgages on one- to four-family residences
(including home equity loans and lines of credit), commercial real estate,
consumer and commercial business loans and, to a lesser extent, construction and
development loans.  We offer a wide variety of secured and unsecured
consumer loan products, including manufactured home loans, automobile loans,
boat loans and recreational vehicle loans.  We intend to continue
emphasizing our residential mortgage, home equity and consumer lending, while
also expanding our emphasis in commercial real estate and commercial business
lending.  In recent years, we have focused on expanding our commercial
loan portfolio.




As part
of our business, we focus on mortgage loan originations, many of which we sell
to Fannie Mae.  We sell these loans with servicing retained to
maintain the direct customer relationship and promote our emphasis on strong
customer service.  We originated $117.6 million and $57.7 million in
one- to four-family residential mortgage loans during the years ended December
31, 2009 and 2008, respectively.  During these same periods, we sold
$84.3 million and $31.6 million, respectively, of one- to four-family
residential mortgage loans.




We offer
a variety of deposit accounts, which are our primary source of funding for our
lending activities.  In recent years we have also relied on Federal
Home Loan Bank advances to augment our deposits and fund the growth of interest
earning assets.  In 2008, we adopted a leverage strategy to use
long-term Federal Home Loan Bank advances to fund asset and loan growth. We also
use short-term advances to meet short term liquidity needs.




The
Company’s earnings are primarily dependent upon our net interest income, the
difference between interest income and interest expense.  Interest
income is a function of the balances of loans and investments outstanding during
a given period and the yield earned on these loans and
investments.  Interest expense is a function of the amount of deposits
and borrowings outstanding during the same period and interest rates paid on
these deposits and borrowings.  The Company’s earnings are also
affected by our provision for loan losses, service charges and fees, gains and
losses from sales of loans and other assets, other income, operating expenses
and income taxes.




During
2009, the Company encountered a number of challenges but also met a number of
its goals.  The declining economy in our market resulted in increased
delinquencies and foreclosures, which required us to increase our reserves and
impacted our 2009 earnings In particular, the increase in the unemployment rate
and the decrease in the housing markets in western Washington had an adverse
impact on our performance.  However, we were still able to meet our
goals of expanding our franchise and increasing our commercial business and real
estate lending activities.  In 2009, we expanded our operations with
two new Bank branches in Port Angeles and Tacoma and acquired the Port Angeles
and Tacoma offices of 1st
Security Bank, including $33.6 million in deposits.  As of December
31, 2009 the Port Angeles branch had $27.3 million in deposit and the Tacoma
branch had $26.7 million in deposits.





38







Our
commercial business and real estate loan portfolios increased 26.3% and 38.7%,
respectively, since the end of 2008. The impact of additional commercial
business and real estate loans has had a positive impact on our net interest
income and has helped to further diversify our loan portfolio mix.




Our
primary market area is Western Washington.  Adverse economic
conditions in that market area can reduce our rate of growth, affect our
customers’ ability to repay loans and adversely impact our financial condition
and earnings.  General economic conditions, including inflation,
unemployment and money supply fluctuations, also may affect our profitability
adversely.  Our market area is undergoing a recession, which has
resulted in higher levels of loan delinquencies, problem assets and
foreclosures, decreased demand for our products and services and a decline in
the value of our loan collateral.  If this recession continues or
becomes more severe, this negative impact on our business, financial condition
and earnings may increase.




Beginning
in 2008, United States and global financial markets have experienced severe
disruption and volatility, and general economic conditions have declined
significantly.  Adverse developments in credit quality, asset values
and revenue opportunities throughout the financial services industry, as well as
general uncertainty regarding the economic, industry and regulatory environment,
have had a marked negative impact on the industry.  Dramatic declines
in the U.S. housing market over the past two years, with falling home prices,
increasing foreclosures and increasing unemployment, have negatively affected
the credit performance of mortgage loans and resulted in significant write-downs
of asset values by many financial institutions.  The United States and
the governments of other countries have taken steps to try to stabilize the
financial system, including investing in financial institutions, and have also
been working to design and implement programs to improve general economic
conditions.  Notwithstanding the actions of the United States and
other governments, these efforts may not succeed in restoring industry, economic
or market conditions and may result in adverse unintended
consequences.  Factors that could continue to pressure financial
services companies, including the Company, are numerous and
include:  (i) worsening credit quality, leading among other things to
increases in loan losses and reserves; (ii) continued or worsening disruption
and volatility in financial markets, leading among other things to continuing
reductions in asset values; (iii) capital and liquidity concerns regarding
financial institutions generally; (iv) limitations resulting from or imposed in
connection with governmental actions intended to stabilize or provide additional
regulation of the financial system; and (v) recessionary conditions that are
deeper or last longer than currently anticipated.




Critical
Accounting Policies




Certain
of our accounting policies are important to an understanding of our financial
condition, since they require management to make difficult, complex or
subjective judgments, which may relate to matters that are inherently
uncertain.  Estimates associated with these policies are susceptible
to material changes as a result of changes in facts and
circumstances.  Facts and circumstances that could affect these
judgments include, but are not limited to, changes in interest rates, changes in
the performance of the economy and changes in the financial condition of
borrowers.  Management believes that its critical accounting policies
include determining the allowance for loan losses, accounting for
other-than-temporary impairment, accounting for mortgage servicing rights,
accounting for other real estate owned, and accounting for deferred income
taxes.  Our accounting policies are discussed in detail in Note 1 of
the Notes to Consolidated Financial Statements included in Item 7 of this Form
10-K annual report.




Allowance for
Loan Loss.  The allowance for loan losses is the amount
estimated by management as necessary to cover losses inherent in the loan
portfolio at the balance sheet date.  The allowance is established
through the provision for loan losses, which is charged to
income.  Determining the amount of the allowance for loan losses
necessarily involves a high degree of judgment.  Among the material
estimates required to establish the allowance are:  loss exposure at
default; the amount and








39








timing of
future cash flows on impacted loans; value of collateral; and determination of
loss factors to be applied to the various elements of the
portfolio.  All of these estimates are susceptible to significant
change.  Management reviews the level of the allowance at least
quarterly and establishes the provision for loan losses based upon an evaluation
of the portfolio, past loss experience, current economic conditions and other
factors related to the collectability of the loan portfolio.  To
strengthen our loan review and classification process, we engage an independent
consultant to review our classified commercial loans and a sampling of our
non-classified commercial loans on a regular basis.  We have enhanced
our credit administration policies and procedures to improve our maintenance of
updated financial data on commercial borrowers.  This change did not
greatly impact the determination of our allowance for loan losses, as we did not
experience any unusual losses on classified loans relative to non-classified
loans.  Although we believe that we use the best information available
to establish the allowance for loan losses, future adjustments to the allowance
may be necessary if economic conditions differ substantially from the
assumptions used in making the evaluation.  In addition, the OTS, as
an integral part of its examination process, periodically reviews our allowance
for loan losses and may require us to recognize adjustments to the allowance
based on its judgments about information available to it at the time of its
examination.  A large loss could deplete the allowance and require
increased provisions to replenish the allowance, which would adversely affect
earnings.




Other-than-temporary
impairment. Management reviews investment securities on an ongoing basis
for the presence of other-than-temporary impairment (OTTI) or permanent
impairment, taking into consideration current market conditions; fair value in
relationship to cost; extent and nature of the change in fair value; issuer
rating changes and trends; whether management intends to sell a security or if
it is likely that the Company will be required to sell the security before
recovery of the amortized cost basis of the investment, which may be upon
maturity; and other factors. For debt securities, if management intends to sell
the security or it is likely that the Company will be required to sell the
security before recovering its cost basis, the entire impairment loss would be
recognized in earnings as an OTTI. If management does not intend to sell the
security and it is not likely that the Company will be required to sell the
security, but management does not expect to recover the entire amortized cost
basis of the security, only the portion of the impairment loss representing
credit losses would be recognized in earnings. The credit loss on a security is
measured as the difference between the amortized cost basis and the present
value of the cash flows expected to be collected. Projected cash flows are
discounted by the original or current effective interest rate depending on the
nature of the security being measured for potential OTTI. The remaining
impairment related to all other factors, i.e., the difference between
the present value of the cash flows expected to be collected and fair value, is
recognized as a charge to other comprehensive loss. Impairment losses related to
all other factors are presented as separate categories within other
comprehensive loss.




Mortgage
Servicing Rights.We record mortgage servicing rights on loans
sold to Fannie Mae with servicing retained.  The Company stratifies
its capitalized mortgage servicing rights based on the type, term and interest
rates of the underlying loans.  Impairment is recognized through a
valuation allowance for each impaired stratum.  Management assesses
impairment of servicing rights by comparing the amortized cost basis to the
estimated fair value to determine if its rights are impaired.  Any
impairment must to be recorded during the period in which it is
identified.  These mortgage servicing rights are separated into two
segments, one for acquired servicing rights of $2.0 million, which are carried
at fair value and one for our originated servicing portfolio of $1.3 million,
which is carried at amortized cost and is periodically evaluated for impairment
based on their fair value, which takes into account the rates and potential
prepayments of those sold loans being serviced. If our mortgage servicing rights
were determined to be impaired, our financial results would be
impacted.




Other Real Estate
Owned.  Other real estate owned represents real estate that the
Company has taken control of in partial or full satisfaction of significantly
delinquent loans. At the time of foreclosure,








40








other
real estate owned is recorded at the lower of the carrying amount of the loan or
fair value less costs to sell, which becomes the property’s new basis. Any
write-downs based on the asset’s fair value at the date of acquisition are
charged to the allowance for loan and lease losses.  After
foreclosure, management periodically performs valuations such that the real
estate is carried at the lower of its new cost basis or fair value, net of
estimated costs to sell.  Subsequent valuation adjustments are
recognized within net (loss) gain on other real estate owned.  Revenue
and expenses from operations and subsequent adjustments to the carrying amount
of the property are included in other non-interest expense in the consolidated
statements of income.  In some instances, the Company may make loans
to facilitate the sales of other real estate owned. Management reviews all sales
for which it is the lending institution for compliance with sales treatment
under provisions established by ASC Topic 360, “Accounting for Sales of Real
Estate”.  Any gains related to sales of other real estate owned may be
deferred until the buyer has a sufficient initial and continuing investment in
the property.




Income
Taxes.  Income taxes are reflected in our financial statements
to show the tax effects of the operations and transactions reported in the
financial statements and consist of taxes currently payable plus deferred
taxes.  ASC Topic 740, “Accounting for Income Taxes,” requires the
asset and liability approach for financial accounting and reporting for deferred
income taxes.  Deferred tax assets and liabilities result from
differences between the financial statement carrying amounts and the tax bases
of assets and liabilities.  They are reflected at currently enacted
income tax rates applicable to the period in which the deferred tax assets or
liabilities are expected to be realized or settled and are determined using the
assets and liability method of accounting.  The deferred income
provision represents the difference between net deferred tax asset/liability at
the beginning and end of the reported period.  In formulating our
deferred tax asset, we are required to estimate our income and taxes in the
jurisdiction in which we operate.  This process involves estimating
our actual current tax exposure for the reported period together with assessing
temporary differences resulting from differing treatment of items, such as
depreciation and the provision for loan losses, for tax and financial reporting
purposes.




Business
and Operating Strategy and Goals




Our
primary objective is to continue to grow Sound Community Bank as a
well-capitalized, profitable, independent, community-oriented financial
institution serving customers in our primary market areas.  Our
strategy is to provide innovative products and superior service to both
individuals and small businesses in our primary market areas, which we currently
provide through our six convenient full service banking centers located in the
heart of downtown Seattle, Tukwila, Mountlake Terrace, Tacoma, Sequim and Port
Angeles, Washington.  We support these banking centers with 24/7
access to on-line banking and participation in a nationwide ATM
network.  Our basic operating strategy and goals are listed
below.




Grow our
franchise and meet competition in our market through relationship banking with
businesses and retail consumers.  We operate with a
service-oriented approach to banking by meeting our customers’ needs and
emphasizing the delivery of a consistent and high-quality level of professional
service.  The proceeds of our recently completed offering allow us to
originate loans for portfolio and provide services consistent with the needs of
customers in our market areas.  We have adopted a leverage strategy to
utilize our deposit franchise along with long-term Federal Home Loan Bank
advances to fund asset and loan growth.  We continue to expand our
business by cross-selling our loan and deposit products and services to our
customers and emphasizing our traditional strengths, which include residential
mortgages, consumer loans, small business lending and core
deposits.  In addition, we will continue to sell a portion of our
residential mortgage portfolio to Fannie Mae on a servicing retained basis.  We
may also seek opportunities to sell loans we originate that are not saleable to
Fannie Mae, generally including land loans, jumbo mortgage loans and
manufactured home loans, but will only sell those loans if we can do so on a
servicing retained basis.  This allows us to maintain our customer








41








relationship
while also having the funds from the sale of the loans available to make
additional mortgage loans.  Our attention to client service and
competitive rates allow us to attract and retain deposit and loan
customers.  We acquired two branches in 2009 from 1st
Security Bank of Washington.  One of the branches acquired was located
in Port Angeles, Washington and the other in Tacoma, Washington.  We
opened a new branch facility in Port Angeles and consolidated the deposit and
loan accounts which were acquired into the new facility.  We
consolidated the operations of our Lakewood branch into the Tacoma
facility.  We do not have plans for branch expansion in 2010, but we
closed our East Marginal Way on March 31, 2010.




Emphasizing lower
cost core deposits to reduce the funding costs of our loan
growth.  We offer personal and business checking accounts, NOW
accounts and savings and money market accounts, which generally are lower-cost
sources of funds than certificates of deposits, and are less sensitive to
withdrawal when interest rates fluctuate. In order to build our core deposit
base, we are pursuing a number of strategies.  We continue to provide
sales promotions on savings and checking accounts to encourage the growth of
these types of deposits.  We require all commercial loan customers to
maintain a deposit relationship with us, generally a business checking account
relationship to the extent practicable, for the term of their
loans.  We have made, and will continue to make, available
preferential loan and time deposit pricing to customers who maintain a
qualifying relationship at the Company. We also continue to accept public funds
from local public agencies. We lowered our weighted average cost of funds in
2009 by 82 basis points.  This decrease was the result of lower market
rates as well as the acquisition of lower cost deposits from 1st
Security Bank.




Growing and
diversifying our loan portfolio by emphasizing the origination of one- to
four-family residential mortgage, home equity, commercial real estate,
commercial business, and consumer loans.  Our infrastructure,
personnel and fixed operating base can support a substantially larger asset
base.  Our strategy for increasing net income includes increasing our
loan originations, particularly with higher yielding commercial, and consumer
loans. Our business plan emphasizes the origination of loans secured by
residential real estate and loans for business purposes, including commercial
real estate loans.  We have utilized our increased capital level
resulting from the offering to make larger commercial real estate and business
loans to meet the demand for these loan products in our primary market
area.  Commercial real estate loans and commercial business loans
generally are originated with higher interest rates compared to one- to
four-family residential mortgage loans and, therefore, have a positive effect on
our net interest rate spread and net interest income. In addition, most of these
loans are originated with adjustable interest rates, which assist us in managing
interest rate risk.




Maintaining
high asset quality.  We have worked to improve asset quality in
recent years, through managing credit risk, however, recent economic conditions
have contributed to an increase in nonperforming assets.  Our
percentage of non-performing assets to total assets increased to 1.48% at
December 31, 2009 from 1.01% at December 31, 2008.  The increase in
2009 is the result of four foreclosed single family residences and seven
repossessed manufactured homes, all of which have been written down to their
estimated net realizable value. We introduce new loan products when we are
confident that our staff has the necessary expertise and that sound underwriting
and collection procedures are in place.  We also underwrite all of our
loans centrally to ensure uniformity and consistency in underwriting
decisions.




Improve
earnings.  Through product selection and pricing and lower cost
funds, we will seek to optimize our interest rate margin while managing our
interest rate risk.  We will seek new sources of non interest
income by emphasizing selective products and services that provide
diversification of revenue sources, including fees and servicing
income.  We also will strive to control operating expenses while
continuing to provide superior personal service to our customers. In 2009,
operating expenses were higher than in 2008 as a result of additional staffing
in our commercial lending division, the addition of two








42








branches,
increases in collection expense and higher FDIC premiums. In 2008, earnings were
lower as the result of lower than expected net interest income due to reductions
in the overall interest rate environment.    Finally, our
provision for loan losses was significantly higher in 2009 than in 2008,
reflecting the deterioration of the economy both nationally and in the markets
where we do business.  While we experienced a net loss of $614,000 in
2009, we were able to increase pre-tax, pre-provision income to $3.2 million
compared to $1.4 million in 2008.




Comparison
of Financial Condition at December 31, 2009 and December 31, 2008




General.  Total
assets increased by $44.3 million, or 15.1%, to $337.8 million at
December 31, 2009 from $293.5 million at December 31, 2008.  The
increase was the result of a $28.0 million, or 10.6%, increase in our loan
portfolio, including loans held for sale, from $264.7 million at December 31,
2008, to $292.7 million at December 31, 2009.  The increase also was
the result of a $10.1 million increase in cash and cash equivalents during
2009.  Additionally, premises and equipment increased $2.0 million, or
128.0%, primarily as a result of leasehold improvements related to our new
branch facility in Port Angeles and the acquisition of the branch facility of
1st Security Bank branch in Tacoma as well as the purchase of the 1st
Security branch in Port Angeles.  This increase in total assets was
funded primarily by a $64.8 million, or 29.1% increase in deposits during 2009,
including $33.6 million in deposits assumed in the 1st Security Bank branch
acquisition.




Loans.  Our
loan portfolio, including loans held for sale, increased $28.0 million, or
10.6%, from $264.7 million at December 31, 2008 to $292.7 million at December
31, 2009.  Loans held for sale increased from $956,000 at December 31,
2008, to $2.9 million at December 31, 2009, reflecting the timing of
transactions and increased loan originations in late 2009, as compared to late
2008.  The changes in the amount of each type of loan in our loan
portfolio comparing the amounts at year-end 2009 to those at year-end 2008 are
disclosed in Note 5 to our financial statements included in Item 8 of the Form
10-K.  The most significant changes in our loan portfolio include a
38.6% increase in our commercial real estate portfolio, a 26.3% increase in our
commercial business portfolio, a 16.2% increase in our one- to four-family real
estate loans, and a 36.1% decrease in automobile loans.  The increases
in one- to four-family, commercial real estate loans, and commercial business
loans are consistent with our operating strategy of growing and diversifying our
loan portfolio.  The decrease in our auto loan and construction and
development portfolios are a result of lower demand in the current economic
environment.




Allowance for
Loan Losses.  The allowance for loan losses is maintained to
cover losses that are probable and can be estimated on the date of the
evaluation in accordance with generally accepted accounting principles in the
United States.  It is our estimate of probable incurred credit losses
in our loan portfolio.




Our
methodology for analyzing the allowance for loan losses consists of specific and
general components.  We stratify the loan portfolio into homogeneous
groups of loans that possess similar loss-potential characteristics and apply an
appropriate loss ratio to the homogeneous pools of loans to estimate the
incurred losses in the loan portfolio.  The amount of loan losses
incurred in our consumer portfolio is estimated by using historical loss ratios
for major loan collateral types adjusted for current factors.  The
historical loss experience is generally defined as an average percentage of net
loan losses to loans outstanding.  A separate valuation of known
losses for individual classified large-balance, non- homogeneous
loans is also conducted in accordance with Codification Standard ASC Topic
310.  The allowance for loan losses on individually analyzed loans
includes commercial business loans and one- to four-family and commercial real
estate loans, where management has concerns about the borrower’s ability to
repay.  Loss estimates include the difference between the current fair
value of the collateral and the loan amount due.






43






Our
allowance for loan losses at December 31, 2009 was $3.5 million or 1.18% of net
loans receivable, compared to $1.3 million or 0.49% of net loans receivable at
December 31, 2008.  The $2.2 million, or 165.5% increase in the
allowance for loan losses reflects the $4.3 million provision for loan losses
established during 2009, as a result of increases in our commercial and
residential loan portfolios during the year and an evaluation of declining
housing and other market conditions in our market and our $2.1 million in net
charge-offs on non-performing loans.  Non-performing loans increased
from $1.3 million at December 31, 2008 to $3.6 million at December 31, 2009,
primarily as a result of deteriorating market conditions in the areas where we
do business.  This increase consists of numerous residential mortgage
loans and one commercial development loan with a principal balance of $1.2
million at December 31, 2009.  Non-performing loans to gross loans
increased to 1.25% at December 31, 2009 from 0.47% at December 31, 2008, due to
declining economic conditions and increased delinquencies.  Other real
estate owned and repossessed assets decreased by $341,000, or 19.8%, from $1.7
million the end of 2008 compared to $1.4 million at the end of
2009.  The Company believes that higher non-performing assets and
charge-offs will continue in 2010 until the housing market and general market
conditions begin to recover.




Mortgage
Servicing Rights.We record mortgage servicing rights on loans
sold to Fannie Mae with servicing retained.  The Company stratifies
its capitalized mortgage servicing rights based on the type, term and interest
rates of the underlying loans.  Impairment is recognized through a
valuation allowance for each impaired stratum.  Management assesses
impairment by comparing the amortized cost basis to the estimated fair value to
determine if its rights are impaired.  Any impairment would be
required to be recorded during the period identified.  These mortgage
servicing rights are separated into two segments, one for acquired servicing
rights of $2.0 million, which are carried at fair value and one for our
originated servicing portfolio of $1.3 million, which is carried at amortized
cost and is periodically evaluated for impairment based on their fair value,
which takes into account the rates and potential prepayments of those sold loans
being serviced.  If our mortgage servicing rights were determined to
be impaired, our financial results would be impacted.




Cash and Cash
Equivalents.  Cash and cash equivalents increased by $10.1
million, or 179.6%, to $15.7 million at December 31, 2009 as a result of recent
increases to our deposit portfolio and proceeds from the sale of
available-for-sale securities.




Securities.Our securities portfolio consists of mortgage-backed securities, all of
which are designated as available-for-sale and carried at market value and
Federal Home Loan Bank stock which is carried at cost.  The securities
portfolio increased to $9.9 million at December 31, 2009 from $8.9 at December
31, 2008.  Our investment portfolio includes $6.6 million in
non-agency mortgage-backed securities, which present a level of credit risk that
does not exist currently with agency-backed securities that are guaranteed by
the United States government. As of December 31, 2009, the unrealized loss on
these non-agency mortgage backed securities was approximately $1.5
million.  In order to monitor this risk, management receives a credit
surveillance report that considers various factors for each security including
original credit scores, loan to value, geography, delinquency and loss
history.  The report also evaluates the underlying loans within the
security to project future losses based on various home price depreciation
scenarios over a three year horizon.  In addition to this analysis,
management receives a valuation report which also considers constant repayment
rates, various credit default rate scenarios and loss
severity for our non-agency mortgage backed securities. Based on this analysis,
management recognized approximately $61,000 of OTTI on this portfolio for the
year ended December 31, 2009.




At
December 31, 2009, we held $2.4 million in shares of Federal Home Loan Bank of
Seattle stock.  Federal Home Loan Bank stock is carried at par and
does not have a readily determinable fair value.  Ownership of Federal
Home Loan Bank stock is restricted to the Federal Home Loan Bank member
institutions, and can only be purchased and redeemed at par.  Due to
ongoing turmoil in the








44







capital
and mortgage markets, the Federal Home Loan Bank of Seattle has a risk-based
capital deficiency largely as a result of write-downs on its private label
mortgage-backed securities portfolios.  Management evaluates Federal
Home Loan Bank stock for impairment.  Management’s determination of
whether these investments are impaired is based on their assessment of the
ultimate recoverability of cost rather than by recognizing temporary declines in
value.  The determination of whether a decline affects the ultimate
recoverability of cost is influenced by criteria such as:  (1) the
significance of any decline in net assets of the Federal Home Loan Bank as
compared to the capital stock amount for the Federal Home Loan Bank and the
length of time this situation has persisted; (2) commitments by the Federal Home
Loan Bank to make payments required by law or regulation and the level of such
payments in relation to the operating performance of the Federal Home Loan Bank;
(3) the impact of legislative and regulatory changes on institutions and,
accordingly, the customer base of the Federal Home Loan Bank; and (4) the
liquidity position of the Federal Home Loan Bank.  Under Federal
Housing Finance Agency regulations, a Federal Home Loan Bank that fails to meet
any regulatory capital requirement may not declare a dividend or redeem or
repurchase capital stock in excess of what is required for members’ current
loans.  According to Standard and Poor’s analysis of the Federal Home
Loan Banks, the Federal Home Loan Bank System has a special public status
(organized under the Federal Home Loan Bank Act of 1932) and may receive
extraordinary support from the U.S. Treasury in a crisis.  Therefore,
the Federal Home Loan Banks can be considered an extension of the government and
the U.S. government would almost certainly support the credit obligations of the
Federal Home Loan Bank system.  Based on the above, we have determined
there is not an other-than-temporary impairment on the Federal Home Loan Bank
stock investment as of December 31, 2009.




Deposits.  Total
deposits increased by $64.8 million, or 29.1%, to $287.6 million at
December 31, 2009 from $222.8 million at December 31,
2008.  During 2009, time deposits increased $11.2 million, money
market accounts increased $29.9 million, savings accounts increased $8.2
million, and demand deposits and interest-bearing checking accounts increased
$15.5 million.  These increases are primarily the result of the $33.6
million in the 1st Security branch acquisition and our continued emphasis to
bring additional core deposits to the Company from our existing consumer and
business customers and Washington public agencies.




A summary
of deposit accounts with the corresponding weighted average cost of funds is
presented below (in thousands).




As
      of December 31, 2009
              
              As
      of December 31, 2008Amount
              
              
              Wtd.
      Avg.
                Rate
              
              Amount
              
              Wtd.
      Avg.
                RateChecking
      (noninterest)
              $
              21,227
              
              
              0.00%
              
              $
              13,177
              
              0.00%NOW
      (interest)
              
              28,197
              
              
              0.24%
              
              
              20,636
              
              0.61%Savings
              
              20,632
              
              
              0.30%
              
              
              12,522
              
              0.75%Money
      Market
              
              81,620
              
              
              0.90%
              
              
              51,744
              
              2.92%Certificates
              
              135,888
              
              
              2.77%
              
              
              124,681
              
              4.11%Total
              $
              287,564
              
              
              1.60%
              
              $
              222,760
              
              3.04%




Borrowings.  Federal
Home Loan Bank advances decreased $22.4 million, or 52.6%, to $20.0 million at
December 31, 2009 from $42.4 million at December 31, 2008.  We
continue to rely on Federal Home Loan
Bank advances to fund interest earning asset growth when deposit growth is
insufficient to fund such growth.  This reliance on borrowings, rather
than deposits, may increase our overall cost of funds. We decreased reliance on
these borrowings during 2009 as the result of organic deposit
growth.




Equity.  Total
equity decreased $1.0 million, or 4.0%, to $25.1 million at December 31, 2009,
from $26.1 million at December 31, 2008.  This primarily reflects
$306,000 in stock repurchases, $159,000 in paid dividends, net losses of
$614,000 and a $147,000 increase in accumulated other comprehensive loss, due to
an increase in the unrealized loss on our available for sale investment
portfolio.





45







Average
Balances, Net Interest Income, Yields Earned and Rates Paid




The
following table presents for the periods indicated the total dollar amount of
interest income from average interest earning assets and the resultant yields,
as well as the interest expense on average interest bearing liabilities,
expressed both in dollars and rates.  Income and yields on tax-exempt
obligations have not been computed on a tax equivalent basis.  All
average balances are monthly average balances.  Non-accruing loans
have been included in the table as loans carrying a zero yield.




Year
      ended December 31,2009
              
              
              2008
              
              
              2007Average
                Outstanding
                Balance
              
              
              Interest
                Earned/
                Paid
              
              
              Yield/
                Rate
              
              
              Average
                Outstanding
                Balance
              
              
              Interest
                Earned/
                Paid
              
              
              Yield/
                Rate
              
              
              Average
                Outstanding
                Balance
              
              
              Interest
                Earned/
                Paid
              
              
              Yield/
                RateInterest-Earning
      Assets:
              
              (Dollars
      in thousands)Loans receivable(1)
              
              $
              280,097
              
              
              $
              17,975
              
              
              
              6.42
              %
              
              $
              247,058
              
              
              $
              16,436
              
              
              
              6.65
              %
              
              $
              216,076
              
              
              $
              14,911
              
              
              
              6.90
              %Mortgage-backed
      securities
              
              
              22,107
              
              
              
              1,153
              
              
              
              5.21
              
              
              
              6,664
              
              
              
              510
              
              
              
              7.85
              
              
              
              118
              
              
              
              11
              
              
              
              9.32Other
              
              
              2
              
              
              
              -
              
              
              
              0.00
              
              
              
              1,796
              
              
              
              13
              
              
              
              0.74
              
              
              
              1,432
              
              
              
              37
              
              
              
              2.58Total
      interest-earning assets(1)
              
              
              302,206
              
              
              
              19,128
              
              
              
              6.33
              
              
              
              255,518
              
              
              
              16,959
              
              
              
              6.64
              
              
              
              217,626
              
              
              
              14,959
              
              
              
              6.87Interest-Bearing
      Liabilities:Savings
      and Money Market accounts
              
              
              83,985
              
              
              
              951
              
              
              
              1.13
              
              
              
              54,042
              
              
              
              1,100
              
              
              
              2.04
              
              
              
              56,512
              
              
              
              1,642
              
              
              
              2.91Demand
      and NOW accounts
              
              
              37,876
              
              
              
              60
              
              
              
              0.16
              
              
              
              36,688
              
              
              
              294
              
              
              
              0.80
              
              
              
              32,727
              
              
              
              288
              
              
              
              0.88Certificate
      accounts
              
              
              145,138
              
              
              
              5,112
              
              
              
              3.52
              
              
              
              111,741
              
              
              
              5,046
              
              
              
              4.52
              
              
              
              96,648
              
              
              
              4,649
              
              
              
              4.81Borrowings
              
              
              29,917
              
              
              
              934
              
              
              
              3.12
              
              
              
              38,474
              
              
              
              1,273
              
              
              
              3.31
              
              
              
              26,511
              
              
              
              1,346
              
              
              
              5.08Total
      interest-bearing liabilities
              
              
              295,910
              
              
              
              7,057
              
              
              
              2.38
              
              
              
              240,945
              
              
              
              7,713
              
              
              
              3.20
              
              
              
              212,398
              
              
              
              7,925
              
              
              
              3.73Net
      interest income
              
              
              
              
              
              
              12,071
              
              
              
              
              
              
              
              
              
              
              $
              9,246
              
              
              
              
              
              
              
              
              
              
              $
              7,034Net
      interest rate spread
              
              
              
              
              
              
              
              
              
              
              3.95
              %
              
              
              
              
              
              
              
              
              
              
              3.34
              %
              
              
              
              
              
              
              
              
              
              
              3.14
              %Net
      earning assets
              
              $
              6,296
              
              
              
              
              
              
              
              
              
              
              $
              14,573
              
              
              
              
              
              
              
              
              
              
              $
              5,228Net
      interest margin
              
              
              
              
              
              
              
              
              
              
              3.99
              %
              
              
              
              
              
              
              
              
              
              
              3.62
              %
              
              
              
              
              
              
              
              
              
              
              3.23
              %Average
      interest-earning assets
                to
      average interest-bearing
                liabilities
              
              
              
              
              
              
              101.78
              %
              
              
              
              
              
              
              
              
              
              
              106.05
              %
              
              
              
              
              
              
              102.46
              %


______________________________________


(1)              Calculated
net of deferred loan fees, loan discounts, loans in process and loss
reserves.





Rate/Volume
Analysis




The
following schedule presents the dollar amount of changes in interest income and
interest expense for major components of interest-earning assets and
interest-bearing liabilities.  It distinguishes between the changes
related to outstanding balances and that due to the changes in interest
rates.  For each category of interest-earning assets and
interest-bearing liabilities, information is provided on changes attributable to
(i) changes in volume (i.e., changes in volume multiplied by old rate) and (ii)
changes in rate (i.e., changes in rate multiplied by old volume).  For
purposes of this table, changes attributable to both rate and volume, which
cannot be segregated, have been allocated proportionately to the change due to
volume and the change due to rate.






46






Year
      ended December 31,
              2009
      vs. 2008
            
            
            Year
      ended December 31,
              2008
      vs. 2007Increase
              (decrease)
      due to
            
            
            Total
              increase
            
            
            Increase
              (decrease)
      due to
            
            
            Total
              increaseVolume
            
            
            Rate
            
            
            (decrease)
            
            
            Volume
            
            
            Rate
            
            
            (decrease)(In
      thousands)Interest-earning
      assets:Loans
      receivable
            
            $
            2,127
            
            
            $
            (490)
            
            
            $
            1,637
            
            
            $
            1,593
            
            
            $
            (68
            )
            
            $
            1,525Mortgage-backed
      securities
            
            
            661
            
            
            
            (18)
            
            
            
            643
            
            
            
            520
            
            
            
            (21
            )
            
            
            499Other
            
            
            (13)
            
            
            
            -
            
            
            
            (13)
            
            
            
            2
            
            
            
            (26
            )
            
            
            (24
            )Total
      interest-earning assets
            
            $
            2,775
            
            
            $
            (508)
            
            
            $
            2,267
            
            
            $
            2,115
            
            
            $
            (115
            )
            
            $
            2,000Interest-bearing
      liabilities:Savings
      and Money Market accounts
            
            $
            343
            
            
            $
            (492)
            
            
            $
            (149)
            
            
            $
            (50
            )
            
            $
            (492
            )
            
            $
            (542
            )Demand
      and NOW accounts
            
            
            7
            
            
            
            (241)
            
            
            
            (234)
            
            
            
            7
            
            
            
            (1
            )
            
            
            6Certificate
      accounts
            
            
            1,186
            
            
            
            (1,120)
            
            
            
            66
            
            
            
            422
            
            
            
            (25
            )
            
            
            397Borrowings
            
            
            (332)
            
            
            
            (7)
            
            
            
            (339)
            
            
            
            150
            
            
            
            (223
            )
            
            
            (73
            )Total
      interest-bearing liabilities
            
            $
            1,204
            
            
            $
            (1,860)
            
            
            
            (656)
            
            
            $
            529
            
            
            $
            (741
            )
            
            
            (212
            )Net
      interest income (loss)
            
            
            
            
            
            
            
            
            
            $
            2,923
            
            
            
            
            
            
            
            
            
            
            $
            2,212





The decrease in prevailing market
interest rates along with maturities of over $90 million in certificates of
deposit during 2009 contributed to the significant decrease in our weighted
average cost of funds between 2008 and 2009.





Comparison
of Results of Operation for the Year Ended December 31, 2009 and
2008




General.Net income decreased $876,000 to a loss of $614,000 for the year ended
December 31, 2009 compared to net income of $262,000 for the year ended December
31, 2008.  The primary reasons for this $876,000 decrease were a $3.2
million increase in the provision for loan losses and a $2.2 million increase in
non-interest expense primarily as a result of higher FDIC and OTS assessments
and expanded branch operations in Port Angeles and Tacoma, which were offset by
a $1.1 million increase in non-interest income, including a $227,000 gain
recognized as a result of the 1st Security Bank of Washington branch
acquisition.




Interest
Income.  Interest income increased by $2.2 million, or 12.8%,
to $19.1 million for the year ended December 31, 2009, from $17.0 million for
the year ended December 31, 2008.  The increase in interest income for
the period reflects the increased amount of loans and securities outstanding
during the 2009 period.




The
weighted average yield on loans decreased from 6.65% for the year ended December
31, 2008, to 6.42% for the year ended December 31, 2009.  The decrease
was primarily the result of the continued historically low rate environment
throughout the year.  The decrease in the weighted average yield on
loans, however, was tempered by the increase in commercial loans, which
typically have higher yields, as a percentage of the entire loan portfolio and
an increase in the origination of single-family mortgage loans from the levels
in 2008.  The weighted average yield on investments was 5.21% for the
year ended December 31, 2009 compared to 7.85% for the same period during 2008,
reflecting generally lower market interest rates and the acquisition of agency
mortgage backed securities, which currently have a lower yield than non-agency
mortgage backed securities.










47







Interest
Expense.Interest expense decreased $656,000, or 8.5%, to $7.1
million for the year ended December 31, 2009, from $7.7 million for the year
ended December 31, 2008.




The
decrease in interest expense for the 2009 period reflects overall lower interest
rates paid on deposits as well as decreased borrowing costs on our Federal Home
Loan Bank advances, notwithstanding the increase in total deposits during the
period.  Our weighted average cost of interest-bearing liabilities was
2.38% for the year ended December 31, 2009, compared to 3.19% for the same
period in 2008.




Interest
paid on deposits decreased $317,000, or 4.9% to $6.1 million for the year ended
December 31, 2009, from $6.4 million for the year ended December 31,
2008.  This decrease resulted from a decrease in the weighted average
cost of deposits, which was offset by a $63.4 million increase in the average
balance of deposits outstanding for the period.  We experienced an 87
basis point decrease in the average rate paid on deposits during the year ended
December 31, 2009 compared to the same period in 2008.  This decrease
in average rates was a result of the repricing of matured certificate deposits
that the Company was able to retain at significantly lower rates as well as
lower interest rates paid on existing savings, interest bearing checking and
money market accounts and an emphasis by the Company on attracting lower-cost
product types such as savings, checking and money market accounts versus
CDs.




Interest
expense on borrowings decreased $339,000, or 26.7%, to $934,000 for the year
ended December 31, 2009 from $1.3 million for the year ended December 31,
2008.  The decrease resulted from an $8.6 million or 22.2% reduction
in our average balance of outstanding overnight borrowings at the Federal Home
Loan Bank.  The cost of borrowings decreased 19 basis points from
3.31% in the 2008 period to 3.12% in the 2009 period.




Net Interest
Income.  Net interest income increased $2.8 million, or 30.6%
to $12.1 million for the year ended December 31, 2009, from $9.2 million for the
year ended December 2008.  The increase in net interest income for the
2009 period primarily resulted from the increased amount of loans and securities
outstanding during the year as well as significantly lower rates on
deposits.  Our net interest margin was 3.99% for the year ended
December 31, 2009, compared to 3.62% for the year ended December 31,
2008.




Provision for
Loan Losses.  We establish provisions for loan losses, which
are charged to earnings, at a level required to reflect management’s best
estimate of the probable incurred credit losses in the loan
portfolio.  In evaluating the level of the allowance for loan losses,
management considers historical loss experience, the types of loans and the
amount of loans in the loan portfolio, adverse situations that may affect
borrowers’ ability to repay, estimated value of any underlying collateral, peer
group data, prevailing economic conditions, and current
factors.  Large groups of smaller balance homogeneous loans, such as
residential real estate, small commercial real estate, home equity and consumer
loans, are evaluated in the aggregate using historical loss factors adjusted for
current economic conditions and other relevant data.  Loans for which
management has concerns about the borrowers’ ability to repay, are evaluated
individually, and specific loss allocations are provided for these loans when
necessary.




A
provision of $4.3 million was made during the year ended December 31, 2009,
compared to provision of $1.1 million during the year ended December 31,
2008.   The higher provision was primarily attributable to
increases in net charge-offs, increases in our commercial loan portfolio, an
increase in our overall loan portfolio and the declining market conditions
nationally and in our market area.  The Company believes that higher
levels of non-performing assets and charge-offs will continue until the housing
market and general economic market conditions begin to recover.





48







At
December 31, 2009, the annualized percentage of net charge-offs to average loans
increased 49 basis points to 0.75% from 0.26% at December 31,
2008.  The ratio of non-performing loans to total loans increased from
0.47% at December 31, 2008 to 1.25% at December 31, 2009.  See Item 1
– Business – Lending Activities -- Non-performing Assets in this Form 10-K for
more information on non-performing loans.




Noninterest
Income.  Noninterest income increased $1.1 million, or 52.1%,
to $3.3 million for the year ended December 31, 2009, from $2.2 million for the
year ended December 31, 2008.  The primary reason for this increase
was an increase in service charges and fee income of $267,000 as a result of
higher checking account service charge revenue, a $721,000 increase in mortgage
servicing income due to our larger servicing portfolio and a $292,000 increase
on the sale of loans and investments.  This was partially offset by a
$131,000 increase in the loss on other real estate owned and repossessed assets
for the year ended December 31, 2009, compared to the same period in
2008.




Noninterest
Expense.  Noninterest expense increased $2.2 million, or 21.8%,
to $12.2 million for the year ended December 31, 2009, compared to $10.0 million
for the year ended December 31, 2008.  The increase during the 2009
period was primarily the result of a $708,000, or 14.2%, increase in salaries
and benefits resulting from increased staffing in our commercial banking
division and Port Angeles and Tacoma branches and a $891,000, or 22.2% increase
in operations and occupancy expenses resulting from expenses related to our new
branch in Port Angeles and the acquisition of two branches from 1st
Security Bank of Washington.  The Company paid $443,000 in additional
FDIC insurance premiums and OTS assessments in 2009 compared to 2008, and data
processing costs increased by $137,000, or 17.9%, in 2009 primarily due to data
conversion costs associated with the branch acquisitions.




Income Tax
Expense.   For the year ended December 31, 2009, we had an
income tax benefit of $465,000 on our pre-tax income as compared to income tax
expense of $45,000 for the year ended December 31, 2008.  The
effective tax rates for December 31, 2009 and December 31, 2008 were 22.4% and
14.7%, respectively.




Liquidity




Liquidity
management is both a daily and longer-term function of the management of the
Company and the Bank.  Excess liquidity is generally invested in
short-term investments, such as overnight deposits and federal
funds.  On a longer term basis, we maintain a strategy of investing in
various lending products and investment securities, including mortgage-backed
securities.  The Company uses its sources of funds primarily to meet
its ongoing commitments, pay maturing deposits, fund deposit withdrawals and
fund loan commitments.




We
maintain cash and investments that qualify as liquid assets to maintain adequate
liquidity to ensure safe and sound operation and meet demands for funds
(particularly withdrawals of deposits).  At December 31, 2009, the
Company had $25.5 million in cash and investment securities available for sale
and $2.9 in loans held for sale generally available for its cash
needs.  We can also generate funds from borrowings, primarily Federal
Home Loan Bank advances.  At December 31, 2009, the Company had the
ability to borrow an additional $98.3 million in Federal Home Loan Bank
advances.




As of
December 31, 2009, our total borrowing capacity was $118.3 million with the
Federal Home Loan Bank of Seattle, subject to certain requirements, with unused
borrowing capacity of $98.3 million at that date.  Our low level of
liquid investment securities creates more reliance on our line of credit with
the Federal Home Loan Bank of Seattle.  In addition, we have
historically sold all of our conforming
mortgage loans in the secondary market to Fannie Mae in order to reduce interest
rate risk and to create still another source of liquidity.






49






We use
our sources of funds primarily to meet ongoing commitments, pay maturing
deposits and fund withdrawals, and to fund loan commitments.  At
December 31, 2009, the approved outstanding loan commitments, including unused
lines and letters of credit, amounted to $35.2 million.  Certificates
of deposit scheduled to mature in one year or less at December 31, 2009, totaled
$88.6 million.  It is management’s policy to manage deposit rates that
are competitive with other local financial institutions.  Based on
this management strategy, we believe that a majority of maturing deposits will
remain with the Company.




Except as
set forth above, management is not aware of any trends, events, or uncertainties
that will have, or that are reasonably likely to have a material impact on
liquidity, capital resources or operations.  Further, management is
not aware of any current recommendations by regulatory agencies which, if they
were to be implemented, would have this effect.




Off-Balance
Sheet Activities




In the
normal course of operations, the Company engages in a variety of financial
transactions that are not recorded in our financial statements.  These
transactions involve varying degrees of off-balance sheet credit, interest rate
and liquidity risks.  These transactions are used primarily to manage
customers’ requests for funding and take the form of loan commitments and lines
of credit.  For the year ended December 31, 2009, we engaged in no
off-balance sheet transactions likely to have a material effect on our financial
condition, results of operations or cash flows.




A summary
of our off-balance sheet loan commitments at December 31, 2009, is as follows
(in thousands):




Off-balance sheet loan
      commitments:Commitments
      to make loans
            $
            1,933Undisbursed
      portion of loans closed
            
            4,455Unused
      lines of credit
            
            28,509Irrevocable
      letters of credit
            
            264Total
      loan commitments
            $
            35,161




Capital




The
Company is subject to minimum capital requirements imposed by the
OTS.  Based on its capital levels at December 31, 2009, the Company
exceeded these requirements as of that date and continues to exceed them as of
the date of this Form 10-K Annual Report.  Consistent with our goals
to operate a sound and profitable organization, our policy is for the Company to
maintain a “well-capitalized” status under the capital categories of the
OTS.  Based on capital levels at December 31, 2009, the Company was
considered to be well-capitalized.  Management monitors the capital
levels of the Company to provide for current and future business opportunities
and to meet regulatory guidelines for “well-capitalized”
institutions.






50







The
following table shows the capital ratios of the Company at December 31,
2009.







Actual
            
            
            Minimum
      Capital
              Requirements
            
            
            Minimum
      Required to
              Be
      Well-Capitalized
              Under
      Prompt
              Corrective
              Action
      ProvisionsAmount
            
            
            Ratio
            
            
            Amount
            
            
            Ratio
            
            
            Amount
            
            
            Rate(Dollars
      in thousands)Risked-based capital
      (to risk-weighted assets)(2)
            
            $
            24,998
            
            
            
            7.4
            %
            
            $
            13,563
            
            
            
            4.0
            %
            
            $
            16,954
            
            
            
            5.0
            %Core capital (to
      risk-weighted assets)(2)
            
            $
            24,998
            
            
            
            10.4
            %
            
            $
            9,594
            
            
            
            4.0
            %(3)
            
            $
            14,391
            
            
            
            6.0
            %Core capital (to
      total adjusted assets)(1)
            
            
            27,996
            
            
            
            11.7
            %
            
            $
            19,189
            
            
            
            8.0
            %
            
            $
            23,986
            
            
            
            10.0
            %


________________________


(1)
            Based
      on total adjusted assets of $339.1
million.


(2)
            Based
      on risk-weighted assets of $239.9
million.


(3)
            The
      Tier 1 risk-based capital requirement for a well-capitalized institution
      is 6% of risk-weighted assets.  See “How We Are Regulated -
      Regulatory Capital Requirements.”





Impact
of Inflation




The
effects of price changes and inflation can vary substantially for most financial
institutions.  While management believes that inflation affects the
growth of total assets, it believes that it is difficult to assess the overall
impact.  Management believes this to be the case due to the fact that
generally neither the timing nor the magnitude of the inflationary changes in
the consumer price index (“CPI”) coincides with changes in interest
rates.  The price of one or more of the components of the CPI may
fluctuate considerably and thereby influence the overall CPI without having a
corresponding affect on interest rates or upon the cost of those goods and
services normally purchased by the Company.  In years of high
inflation and high interest rates, intermediate and long-term interest rates
tend to increase, thereby adversely impacting the market values of investment
securities, mortgage loans and other long-term fixed rate loans.  In
addition, higher short-term interest rates caused by inflation tend to increase
the cost of funds.  In other years, the opposite may
occur.




Item
7A.  Quantitative and Qualitative Disclosures About Market
Risk




Asset/Liability
Management




Our Risk When
Interest Rates Change.  The rates of interest we earn on assets
and pay on liabilities generally are established contractually for a period of
time.  Market rates change over time.  Like other financial
institutions, our results of operations are impacted by changes in interest
rates and the interest rate sensitivity of our assets and
liabilities.  The risk associated with changes in interest rates and
our ability to adapt to these changes is known as interest rate risk and is our
most significant market risk.




How We Measure
Our Risk of Interest Rate Changes.  As part of our attempt to
manage our exposure to changes in interest rates and comply with applicable
regulations, we monitor our interest rate risk.  In doing so, we
analyze and manage assets and liabilities based on their interest rates and
payment streams, timing of maturities, repricing opportunities, and sensitivity
to actual or potential changes in market interest rates.




The
Company is subject to interest rate risk to the extent that its interest-bearing
liabilities, primarily deposits and Federal Home Loan Bank advances, reprice
more rapidly or at different rates than its interest-earning
assets.  In order to minimize the potential for adverse effects of
material prolonged increases or decreases in interest rates on our results of
operations, we have adopted an asset and liability








51







management
policy.  The board of directors sets the asset and liability policy
for the Company, which is implemented by the asset/liability
committee.




The
purpose of the asset/liability committee is to communicate, coordinate, and
control asset/liability management consistent with our business plan and
board-approved policies.  The committee establishes and monitors the
volume and mix of assets and funding sources, taking into account relative costs
and spreads, interest rate sensitivity and liquidity needs.  The
objectives are to manage assets and funding sources to produce results that are
consistent with liquidity, capital adequacy, growth, risk and profitability
goals.




The
committee generally meets monthly to, among other things, protect capital
through earnings stability over the interest rate cycle; maintain our
well-capitalized status; and provide a reasonable return on
investment.  The committee recommends appropriate strategy changes
based on this review.  The committee is responsible for reviewing and
reporting the effects of the policy implementations and strategies to the board
of directors at least quarterly.  Senior managers oversee the process
on a daily basis.




A key
element of the Company’s asset/liability management plan is to protect net
earnings by managing the maturity or repricing mismatch between its
interest-earning assets and rate-sensitive liabilities.  We seek to
reduce exposure to earnings by extending funding maturities through the use of
Federal Home Loan Bank advances, through the use of adjustable rate loans and
through the sale of certain fixed rate loans in the secondary
market.




As part
of its efforts to monitor and manage interest rate risk, the Company uses the
net portfolio value (“NPV”) methodology adopted by the OTS as part of its
capital regulations.  In essence, this approach calculates the
difference between the present value of expected cash flows from assets and
liabilities.  Management and the board of directors review NPV
measurements on a quarterly basis to determine whether the Company’s interest
rate exposure is within the limits established by the board of
directors.




The
Company’s asset/liability management strategy dictates acceptable limits on the
amounts of change in given changes in interest rates.  For interest
rate increases of 100, 200, and 300 basis points, our policy dictates that our
NPV ratio should not fall below 7%, 7%, and 5%, respectively.  As
illustrated in the table below, we were in compliance with this aspect of our
asset/liability management policy at December 31, 2009, except in the case of a
200 basis point increase in rates.




The table
presented below, as of December 31, 2009 (the latest available information), is
an internal analysis of our interest rate risk as measured by changes in NPV for
instantaneous and sustained parallel shifts in the yield curve, in 100 basis
point increments, up 300 basis points and down 100 basis points as any further
decline in rates is unlikely.


52


As
illustrated in the table below, the Company would benefit from a decrease in
market rates of interest.  Our NPV would be negatively impacted by an
increase in interest rates.  An increase in rates would negatively
impact our NPV as a result of deposit accounts and Federal Home Loan Bank
borrowings repricing more rapidly than loans and securities due to the fixed
rate nature of a large portion of our
loan and security portfolios.  As rates rise, the market value of
fixed rate assets declines due to both the rate increases and slowing
prepayments.





December
      31, 2009Change
      in
              Interest
              Rates
      in
            
            Net
      Portfolio Value
            
            NPVBasis
      Points
            
            $
      Amount
            
            $
      Change
            
            %
      Change
            
            Ratio
      %(Dollars
      in thousands)+300bp
            
            23,520
            
            -10,739
            
            -31%
            
            -277bp+200bp
            
            27,541
            
            -6,718
            
            -20%
            
            -170bp+100bp
            
            31,146
            
            -3,113
            
            -9%
            
            -77bp0bp
            
            34,259-50bp
            
            35,520
            
            1,261
            
            +4%
            
            30bp-100bp
            
            36,269
            
            2,010
            
            +6%
            
            48bp




In
addition to monitoring selected measures of NPV, management also monitors
effects on net interest income resulting from increases or decrease in
rates.  This process is used in conjunction with NPV measures to
identify excessive interest rate risk.  In managing our
assets/liability mix, depending on the relationship between long and short term
interest rates, market conditions and consumer preference, we may place somewhat
greater emphasis on maximizing its net interest margin than on strictly matching
the interest rate sensitivity of its assets and
liabilities.  Management also believes that the increased net income
which may result from an acceptable mismatch in the actual maturity or repricing
of its asset and liability portfolios can, during periods of declining or stable
interest rates, provide sufficient returns to justify the increased exposure to
sudden and unexpected increases in interest rates which may result from such a
mismatch.  Management believes that the Company’s level of interest
rate risk is acceptable under this approach.




In
evaluating the Company’s exposure to interest rate movements, certain
shortcomings inherent in the method of analysis presented in the foregoing table
must be considered.  For example, although certain assets and
liabilities may have similar maturities or repricing periods, they may react in
different degrees to changes in market interest rates.  Also, the
interest rates on certain types of assets and liabilities may fluctuate in
advance of changes in market interest rates, while interest rates on other types
may lag behind changes in interest rates.  Additionally, certain
assets, such as adjustable rate mortgages, have features which restrict changes
in interest rates on a short-term basis and over the life of the
asset.  Further, in the event of a significant change in interest
rates, prepayment and early withdrawal levels would likely deviate significantly
from those assumed above.  Finally, the ability of many borrowers to
service their debt may decrease in the event of an interest rate
increase.  The Company considers all of these factors in monitoring
its exposure to interest rate risk.





53





Item
8.  Financial Statements and Supplementary Data




REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM







To the
Board of Directors


Sound
Financial, Inc.








We have
audited the accompanying consolidated balance sheets of Sound Financial, Inc and
Subsidiary (the Company) as of December 31, 2009 and 2008, and the related
consolidated statements of operations, stockholders’ equity, and cash flows for
each of the two years in the period ended December 31, 2009. These consolidated
financial statements are the responsibility of the Company’s management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.





We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audits to obtain reasonable assurance about whether the
consolidated financial statements are free of material misstatement. The Company
is not required to have, nor were we engaged to perform, an audit of its
internal control over financial reporting. Our audits included consideration of
internal control over financial reporting as a basis for designing audit
procedures that are appropriate in the circumstances, but not for the purpose of
expressing an opinion on the effectiveness of the Company’s internal control
over financial reporting. Accordingly, we express no such opinion. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as well
as evaluating the overall consolidated financial statement presentation. We
believe that our audits provide a reasonable basis for our opinion.





In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Sound
Financial, Inc and Subsidiary as of December 31, 2009 and 2008, and the results
of their operations and their cash flows for each of the two years in the period
ended December 31, 2009, in conformity with accounting principles generally
accepted in the United States of America.





/s/ Moss
Adams LLP





Everett,
Washington


March 31,
2010





54





SOUND
FINANCIAL, INC. AND SUBSIDIARY


Consolidated
Balance Sheets





DECEMBER
      31,
              
              
              DECEMBER
      31,2009
              
              
              2008ASSETSCash
      and cash equivalents
              
              $
              15,678,766
              
              
              $
              5,607,800Securities
      available-for-sale (AFS), at fair value
              
              
              9,899,092
              
              
              
              8,929,798Federal
      Home Loan Bank (FHLB) stock, at cost
              
              
              2,444,000
              
              
              
              2,444,000Loans
      held for sale
              
              
              2,857,700
              
              
              
              955,595Loans
              
              
              289,824,133
              
              
              
              263,712,797Less
      allowance for loan losses
              
              
              (3,467,567
              )
              
              
              (1,305,950
              )Total
      loans
              
              
              286,356,566
              
              
              
              262,406,847Accrued
      interest receivable
              
              
              1,305,590
              
              
              
              1,219,645Premises
      and equipment, net
              
              
              3,523,753
              
              
              
              1,545,705Bank-owned
      life insurance
              
              
              6,462,892
              
              
              
              6,195,055Mortgage
      servicing rights, at fair value
              
              
              2,017,489
              
              
              
              -Mortgage
      servicing rights, at cost
              
              
              1,309,809
              
              
              
              863,146Other
      real estate owned and repossessed assets
              
              
              1,383,638
              
              
              
              1,724,531Other
      assets
              
              
              4,566,464
              
              
              
              1,605,177Total
      assets
              
              $
              337,805,759
              
              
              $
              293,497,299
  LIABILITIESDepositsInterest-bearing
              
              $
              266,337,202
              
              
              $
              209,583,218Noninterest-bearing
      demand
              
              
              21,226,575
              
              
              
              13,176,999Total
      deposits
              
              
              287,563,777
              
              
              
              222,760,217Borrowings
              
              
              20,000,000
              
              
              
              42,219,355Accrued
      interest payable
              
              
              166,043
              
              
              
              259,757Other
      liabilities
              
              
              4,668,216
              
              
              
              1,825,143Advance
      payments from borrowers for taxes and insurance
              
              
              339,566
              
              
              
              330,319Total liabilities
              
              
              312,737,602
              
              
              
              267,394,791COMMITMENTS
      AND CONTINGENCIES (NOTE 16)STOCKHOLDERS'
      EQUITYPreferred
      stock, $0.01 par value, 1,000,000 shares authorized
              
              
              -
              
              
              
              -Common
      stock, $0.01 par value, 24,000,000 shares authorized, 3,000,095 issued and
                2,954,295
      outstanding as of December 31, 2009, and 2,948,063 shares issued and
                2,948,063
      outstanding as of December 31, 2008
              
              
              30,001
              
              
              
              29,480Additional
      paid-in capital
              
              
              11,687,641
              
              
              
              11,936,035Unearned
      shares - Employee Stock Ownership Plan (“ESOP”)
              
              
              (924,480
              )
              
              
              (1,057,997
              )Retained
      earnings
              
              
              15,214,549
              
              
              
              15,987,547Accumulated
      other comprehensive loss, net of tax
              
              
              (939,554
              )
              
              
              (792,557
              )Total
      stockholders’ equity
              
              
              25,068,157
              
              
              
              26,102,508$
              337,805,759
              
              
              $
              293,497,299










See notes to consolidated financial
statements





55





SOUND
FINANCIAL, INC. AND SUBSIDIARY


Consolidated
Statements of Operations





YEARS
      ENDED DECEMBER 31,2009
            
            
            2008INTEREST
      INCOMELoans,
      including fees
            
            $
            17,975,345
            
            
            $
            16,435,721Interest
      and dividends on investments, cash and cash equivalents
            
            
            1,152,816
            
            
            
            522,933Total
      interest income
            
            
            19,128,161
            
            
            
            16,958,654INTEREST
      EXPENSEDeposits
            
            
            6,123,332
            
            
            
            6,440,185Other
      interest expense
            
            
            934,078
            
            
            
            1,273,281Total
      interest expense
            
            
            7,057,410
            
            
            
            7,713,466NET
      INTEREST INCOME
            
            
            12,070,751
            
            
            
            9,245,188PROVISION
      FOR LOAN LOSSES
            
            
            4,275,000
            
            
            
            1,110,000NET
      INTEREST INCOME AFTER PROVISIONFOR
      LOAN LOSSES
            
            
            7,795,751
            
            
            
            8,135,188NONINTEREST
      INCOMEService
      charges and fee income
            
            
            2,080,723
            
            
            
            1,813,343Earnings
      on cash surrender value of bank owned life insurance
            
            
            267,837
            
            
            
            159,643Mortgage
      servicing income
            
            
            866,624
            
            
            
            333,834Fair
      value gain on mortgage servicing rights
            
            
            124,618
            
            
            
            -Gain
      on sale of securities
            
            
            272,845
            
            
            
            153,633Impairment
      on Securities
            
            
            (61,220
            )
            
            
            -Gain
      (loss) on sale of loans
            
            
            157,385
            
            
            
            (15,795
            )Gain
      on bargain purchase of branches
            
            
            226,816
            
            
            
            -Loss
      on sale of assets
            
            
            (627,089
            )
            
            
            (269,340
            )Total
      noninterest income
            
            
            3,308,539
            
            
            
            2,175,318NONINTEREST
      EXPENSESalaries
      and benefits
            
            
            5,699,633
            
            
            
            4,991,553Operations
            
            
            3,723,231
            
            
            
            3,004,386Regulatory
      assessments
            
            
            677,392
            
            
            
            235,369Occupancy
            
            
            1,177,498
            
            
            
            1,004,751Data
      processing
            
            
            904,966
            
            
            
            767,777Total
      noninterest expense
            
            
            12,182,720
            
            
            
            10,003,836INCOME
      (LOSS) BEFORE PROVISION (BENEFIT) FOR INCOME TAXES
            
            
            (1,078,430
            )
            
            
            306,670PROVISION
      (BENEFIT) FOR INCOME TAXES
            
            
            (464,627
            )
            
            
            45,095NET
      INCOME (LOSS)
            
            $
            (613,803
            )
            
            $
            261,575BASIC
      EARNINGS (LOSS) PER SHARE
            
            $
            (0.21
            )
            
            $
            0.09DILUTED
      EARNINGS (LOSS) PER SHARE
            
            $
            (0.21
            )
            
            $
            0.09







See
notes to consolidated financial statements





56





SOUND
FINANCIAL, INC. AND SUBSIDIARY


Consolidated
Statements of Stockholders’ Equity




Shares
            
            
            Common
              Stock
            
            
            Additional
              Paid-in
              Capital
            
            
            Unearned
              ESOP
              Shares
            
            
            Retained
              Earnings
            
            
            Accumulated
              Other
              Comprehensive
              Loss,
      net of tax
            
            
            Total
              Stockholders’
      EquityBALANCE,
      December 31, 2007
            
            
            
            
            $
            -
            
            
            $
            -
            
            
            $
            -
            
            
            $
            15,885,167
            
            
            $
            3,161
            
            
            $
            15,888,328Comprehensive
      income:Net
      income
            
            
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            261,575
            
            
            
            -
            
            
            
            261,575Net
      loss in fair value of
              investments
      available
              for
      sale, net of tax
              benefit
      of $408,287
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (795,718
            )
            
            
            (795,718
            )(534,143
            )Cash
      dividend declared
              and
      paid ($0.12 per share)
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (159,195
            )
            
            
            
            
            
            
            (159,195
            )Common
      Stock Issued
            
            
            2,948,063
            
            
            
            29,480
            
            
            
            11,918,078
            
            
            
            (1,155,600
            )
            
            
            
            
            
            
            
            
            
            
            10,791,958Allocation
      of ESOP shares
            
            
            
            
            
            
            
            
            
            
            17,957
            
            
            
            97,603
            
            
            
            
            
            
            
            
            
            
            
            115,560BALANCE,
      December 31, 2008
            
            
            2,948,063
            
            
            
            29,480
            
            
            
            11,936,035
            
            
            
            (1,057,997
            )
            
            
            15,987,547
            
            
            
            (792,557
            )
            
            
            26,102,508Comprehensive
      loss:Net
      loss
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (613,803
            )
            
            
            
            
            
            
            (613,803
            )Net
      loss in fair value of
              investments
      available
              for sale, net of tax
              benefit of $75,726
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (146,997
            )
            
            
            (146,997
            )(760,800
            )Cash
      dividend declared
              and paid ($0.12 per share)
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (159,195
            )
            
            
            
            
            
            
            (159,195
            )Restricted
      stock awards
            
            
            52,032
            
            
            
            521
            
            
            
            (521
            )
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            -Common
      stock repurchased
            
            
            (45,800
            )
            
            
            
            
            
            
            (306,132
            )
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (306,132
            )Compensation
      related to stock
              options and restricted stock
            
            
            
            
            
            
            
            
            
            
            120,000
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            120,000Allocation
      of ESOP shares
            
            
            
            
            
            
            
            
            
            
            (61,741
            )
            
            
            133,517
            
            
            
            
            
            
            
            
            
            
            
            71,776Balances
      at December 31, 2009
            
            
            2,954,295
            
            
            $
            30,001
            
            
            $
            11,687,641
            
            
            $
            (924,480
            )
            
            $
            15,214,549
            
            
            $
            (939,554
            )
            
            $
            25,068,157





See
notes to consolidated financial statements





57





SOUND
FINANCIAL, INC. AND SUBSIDIARY


Consolidated
Statements of Cash Flows


Year
      Ended December 31,2009
              
              
              2008CASH
      FLOWS FROM OPERATING ACTIVITIESNet
      income (loss)
              
              $
              (613,803
              )
              
              $
              261,575Adjustments
      to reconcile net income (loss) to net cash from operating
      activitiesAccretion
      of net premium on investments
              
              
              (25,388
              )
              
              
              (90,047
              )Impairment
      on securities
              
              
              61,220
              
              
              
              -Gain
      on sale of securities
              
              
              (272,845
              )
              
              
              (153,633
              )Provision
      for loan losses
              
              
              4,275,000
              
              
              
              1,110,000Depreciation
      and amortization
              
              
              492,490
              
              
              
              404,382Compensation
      expense related to stock options and restricted stock
              
              
              120,000
              
              
              
              -Additions
      to mortgage servicing rights
              
              
              (893,112
              )
              
              
              (339,808
              )Fair
      value gain on mortgage servicing rights
              
              
              (124,618
              )
              
              
              -Amortization
      of mortgage servicing rights
              
              
              475,220
              
              
              
              341,608Purchase
      of mortgage servicing rights
              
              
              (1,921,642
              )
              
              
              -Increase
      in cash surrender value of bank owned life insurance
              
              
              (267,837
              )
              
              
              (159,643
              )Deferred
      income tax
              
              
              (721,000
              )
              
              
              (286,000
              )Proceeds
      from sale of loans
              
              
              84,299,072
              
              
              
              31,552,290Originations
      of loans held for sale
              
              
              (86,148,048
              )
              
              
              (31,701,551
              )Loss
      on sale of other real estate owned and repossessed assets
              
              
              627,089
              
              
              
              269,340(Gain)
      loss on sale of loans
              
              
              (157,385
              )
              
              
              15,795Gain
      on bargain purchase of branches
              
              
              (226,816
              )
              
              
              -(Decrease)
      increase in operating assets and liabilitiesAccrued
      interest receivable
              
              
              (85,945
              )
              
              
              (168,169
              )Other
      assets
              
              
              (1,463,745
              )
              
              
              94,961Accrued
      interest payable
              
              
              (93,714
              )
              
              
              49,239Other
      liabilities
              
              
              2,843,074
              
              
              
              (541,644
              )Net
      cash from operating activities
              
              
              177,267
              
              
              
              658,695CASH
      FLOWS FROM INVESTING ACTIVITIESProceeds
      from maturities and sales of available for sale
investments
              
              
              34,211,150
              
              
              
              832,450Purchase
      of available for sale investments
              
              
              (35,166,155
              )
              
              
              (10,648,170
              )Cash
      proceeds from branch acquisitions
              
              
              31,729,000
              
              
              
              -Purchase
      of bank owned life insurance
              
              
              -
              
              
              
              (2,000,000
              )Purchase
      of FHLB Stock
              
              
              -
              
              
              
              (1,124,500
              )Net
      increase in loans
              
              
              (31,232,424
              )
              
              
              (47,912,610
              )Improvements
      to OREO and other repossessed assets
              
              
              (81,048
              )
              
              
              (159,966
              )Proceeds
      from sale of OREO and other repossessed assets
              
              
              2,432,813
              
              
              
              3,258,725Purchases
      of premises and equipment
              
              
              (2,470,538
              )
              
              
              (545,234
              )Net
      cash from investing activities
              
              
              (577,202
              )
              
              
              (58,299,305
              )CASH
      FLOWS FROM FINANCING ACTIVITIESNet
      increase in deposits, net of acquired deposits
              
              
              33,074,560
              
              
              
              19,969,018Proceeds
      from borrowings
              
              
              98,530,000
              
              
              
              26,950,000Repayment
      of borrowings
              
              
              (120,749,355
              )
              
              
              (600,000
              )Net
      proceeds from stock issuance
              
              
              -
              
              
              
              10,809,915Repurchase
      of common stock
              
              
              (306,132
              )
              
              
              -Cash
      dividends paid
              
              
              (159,195
              )
              
              
              (159,195
              )ESOP
      Shares released
              
              
              71,776
              
              
              
              97,603Net
      change in advances from borrowers for taxes and insurance
              
              
              9,247
              
              
              
              76,106Net
      cash from financing activities
              
              
              10,470,901
              
              
              
              57,143,447INCREASE
      (DECREASE) IN CASHAND
      CASH EQUIVALENTS
              
              
              10,070,966
              
              
              
              (497,163
              )CASH
      AND CASH EQUIVALENTS, beginning of year
              
              
              5,607,800
              
              
              
              6,104,963CASH
      AND CASH EQUIVALENTS, end of year
              
              $
              15,678,766
              
              
              $
              5,607,800
   58
  SOUND
FINANCIAL, INC. AND SUBSIDIARY
 Consolidated
Statements of Cash Flows
   SUPPLEMENTAL
      CASH FLOW INFORMATIONCash
      paid for income taxes
              
              $
              20,000
              
              
              $
              315,000Interest
      paid on deposits and FHLB advances
              
              $
              7,151,124
              
              
              $
              7,664,227Transfer
      to other real estate owned
              
              $
              2,637,961
              
              
              $
              3,632,841Net
      assets acquired from 1st Security Bank of WashingtonAssets acquired
              
              $
              33,912,000
              
              
              $
              -Liabilities assumed
              
              $
              33,685,000
              
              
              $
              -





See
notes to consolidated financial statements





































59





SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statement





Note
1 - Organization and significant accounting policies




Sound
Financial, Inc. (“Sound Financial” or the “Company”) is a federally chartered
stock holding Company and is subject to regulation by the Office of Thrift
Supervision (“OTS”).  Sound Financial, Inc. was organized on January
8, 2008, as part of Sound Community Bank’s reorganization into the mutual
holding Company form of organization.  As part of the reorganization,
Sound Community Bank (“Bank”) (i) converted to a stock savings bank as the
successor to Sound Community Bank in its mutual form (which was originally
chartered as a credit union in 1953; (ii) organized Sound Financial, Inc., which
owns 100% of the common stock of Sound Community Bank; and (iii) organized Sound
MHC, which currently owns 54% of the common stock of Sound Financial,
Inc.  Sound MHC has no other activities or operations other than its
ownership of Sound Financial, Inc.  Sound Community Bank succeeded to
the business and operations of the Company in its mutual form and Sound
Financial, Inc. has no significant assets other than all of the outstanding
shares of common stock of Sound Community Bank, its loan to the Sound Financial,
Inc.’s Employee Stock Ownership Plan and certain liquid assets.




In
connection with the above-mentioned reorganization, Sound Financial sold
1,297,148 shares of common stock in a subscription offering that closed on
January 8, 2008.  Those shares constitute 44% of the outstanding
shares of common stock of Sound Financial.  Sound Financial also
issued 29,480 shares of common stock to Sound Community Foundation, a charitable
foundation created by Sound Community Bank in connection with the mutual holding
Company reorganization and subscription offering.  The remaining
1,621,435 shares of common stock of Sound Financial outstanding were issued in
accordance with federal law to Sound Community MHC, a federal mutual holding
Company (“MHC”).




Sound
Community Bank is a federal mutual savings association holding a corporate
charter under Section 5 of the Federal Home Owners’ Loan Act. The consolidated
financial statements include the accounts of Sound Community Bank and its wholly
owned subsidiary, ORCA General, Inc. (collectively, the Company). ORCA General,
Inc. originates mortgages that are purchased by the Company for later sale on
the secondary market or for retention in the Company’s portfolio. Material
intercompany balances have been eliminated in consolidation. The subsidiary has
been inactive since December 31, 2003. On May 19, 2003, the Company,
formerly known as Credit Union of the Pacific, a state-chartered credit union
organized under the Washington Credit Union Act, consummated its charter
conversion to a federal mutual savings association.




Use of estimates in the preparation
of financial statements - The preparation of financial statements in
conformity with accounting principles generally accepted in the United States of
America requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities and disclosure of contingent assets
and liabilities at the date of the financial statements and the reported amounts
of income and expenses during the reporting period. Actual results could differ
from those estimates. Material estimates that are particularly susceptible to
significant change in the near term relate to the determination of the allowance
for loan losses, mortgage servicing rights, other real estate owned and deferred
income taxes.




Cash and cash equivalents-For
purposes of reporting cash flows, cash and cash equivalents include cash on hand
and amounts due from banks.  Cash equivalents have an original
maturity of three months or less and may exceed federally insured
limits.




Securities available-for-sale
- Securities available-for-sale consist of debt securities that the Company has
the intent and ability to hold for an indefinite period, but not necessarily to
maturity. Such securities may be sold to implement the Company’s asset/liability
management strategies and in response to changes in interest rates and similar
factors. Securities available-for-sale are reported at fair value.











60





SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements




Unrealized gains and losses, net of the
related deferred tax effect, are reported as a net amount in a separate
component of equity entitled “accumulated other comprehensive loss”. Realized
gains and losses on securities available-for-sale, determined using the specific
identification method, are included in earnings.  Amortization of
premiums and accretion of discounts are recognized as adjustments to interest
income.




Purchase premiums and discounts are
recognized in interest income using the interest method over the period to
maturity. Gains and losses on the sale of securities are recorded on the trade
date and are determined using the specific identification method.




Management reviews investment
securities on an ongoing basis for the presence of other-than-temporary
impairment (OTTI) or permanent impairment, taking into consideration current
market conditions; fair value in relationship to cost; extent and nature of the
change in fair value; issuer rating changes and trends; whether management
intends to sell a security or if it is likely that the Company will be required
to sell the security before recovery of the amortized cost basis of the
investment, which may be upon maturity; and other factors. For debt securities,
if management intends to sell the security or it is likely that the Company will
be required to sell the security before recovering its cost basis, the entire
impairment loss would be recognized in earnings as an OTTI. If management does
not intend to sell the security and it is not likely that the Company will be
required to sell the security, but management does not expect to recover the
entire amortized cost basis of the security, only the portion of the impairment
loss representing credit losses would be recognized in earnings. The credit loss
on a security is measured as the difference between the amortized cost basis and
the present value of the cash flows expected to be collected. Projected cash
flows are discounted by the original or current effective interest rate
depending on the nature of the security being measured for potential OTTI. The
remaining impairment related to all other factors, i.e., the difference between
the present value of the cash flows expected to be collected and fair value, is
recognized as a charge to other comprehensive loss. Impairment losses related to
all other factors are presented as separate categories within other
comprehensive loss.




Loans held-for-sale - To
mitigate interest rate sensitivity, from time to time, certain fixed rate loans
are identified as held-for-sale in the secondary market. Accordingly, such loans
are classified as held-for-sale in the consolidated balance sheets and are
carried at the lower of aggregate cost or estimated market value in the
aggregate. Net unrealized losses, if any, are recognized through a valuation
allowance by charges to income. Mortgage loans held-for-sale are generally sold
with the mortgage servicing rights retained by the Company. Gains or losses on
sales of loans are recognized based on the difference between the selling price
and the carrying value of the related loans sold based on the specific
identification method.





Loans - The Company grants
mortgage, commercial, and consumer loans to customers. A substantial portion of
the loan portfolio is represented by mortgage loans throughout the Puget Sound
region and in Clallam County of Washington State. The ability of the Company’s
debtors to honor their contracts is dependent upon the real estate and general
economic conditions in this area.




Loans
that management has the intent and ability to hold for the foreseeable future or
until maturity or pay-off generally are reported at their outstanding unpaid
principal balances adjusted for any charge-offs, the allowance for loan losses,
and any deferred fees or costs on origination of loans. Interest income is
accrued on the unpaid principal balance. Loan origination fees, net of certain
direct origination costs, are deferred and recognized as an adjustment of the
related loan yield using the interest method amortized over the contractual life
of the loan.




The
accrual of interest on mortgage and commercial loans is discontinued at the time
the loan is 90 days past due unless the credit is well secured and in process of
collection. Loans are typically charged off no later than 120 days past due.
Past due status is based on contractual terms of the loan. In all cases, loans
are placed on nonaccrual or charged off at an earlier date if collection of
principal or interest is considered doubtful.





61







SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements






All
interest accrued but not collected for loans that are placed on nonaccrual or
charged off is reversed against interest income. The interest on these loans is
accounted for on the cash-basis or cost-recovery method, until qualifying for
return to accrual. Loans are returned to accrual status when all of the
principal and interest amounts contractually due are brought current and future
payments are reasonably assured.




Allowance for loan losses -
The allowance for loan losses is maintained at a level sufficient to provide for
probable credit losses based upon evaluating known and inherent risks in the
loan portfolio. The allowance is provided based upon management’s continuing
analysis of the pertinent factors underlying the quality of the loan portfolio.
These factors include changes in the size and composition of the loan portfolio,
delinquency levels, actual loan loss experience, current economic conditions,
and detailed analysis of individual loans for which full collectability may not
be assured. The detailed analysis includes techniques to estimate the fair value
of loan collateral and the existence of potential alternative sources of
repayment. The allowance consists of specific, general, and unallocated
components. The specific component relates to loans that are classified as
doubtful, substandard, or special mention.




For such
loans that are also classified as impaired, an allowance is established when the
discounted cash flows (or collateral value or observable market price) of the
impaired loan are lower than the carrying value of that loan. The general
component covers non-classified loans and is based upon historical loss
experience adjusted for qualitative factors.





An unallocated component is maintained
to cover uncertainties that could affect management’s estimate of probable
losses. The unallocated component of the allowance reflects the margin of
imprecision inherent in the underlying assumptions used in the methodologies for
estimating specific and general losses in the portfolio.






The
appropriateness of the allowance for loan losses is estimated based upon those
factors and trends identified by management at the time consolidated financial
statements are prepared. When available information confirms that specific loans
or portions thereof are uncollectible, identified amounts are charged against
the allowance for credit losses.




The
existence of some or all of the following criteria will generally confirm that a
loss has been incurred: the loan is significantly delinquent and the borrower
has not demonstrated the ability or intent to bring the loan current; the
Company has no recourse to the borrower, or if it does, the borrower has
insufficient assets to pay the debt; the estimated fair value of the loan
collateral is significantly below the current loan balance, and there is little
or no near-term prospect for improvement.




A loan is
considered impaired when it is probable that the Company will be unable to
collect all amounts (principal and interest) due according to the contractual
terms of the loan agreement. Smaller balance homogeneous loans, such as
residential mortgage loans and consumer loans, are collectively evaluated for
probable and reasonably estimated loss. When a loan has been identified as being
impaired, the amount of the impairment is measured by using discounted cash
flows, except when, as a practical expedient, the current fair value of the
collateral, reduced by costs to sell, is used. When the measurement of the
impaired loan is less than the recorded investment in the loan (including
accrued interest), impairment is recognized by creating or adjusting an
allocation of the allowance for loan losses.




The
provision for loan losses is charged against income and is added to the
allowance for loan losses based on quarterly assessments of the loan portfolio.
The allowance for loan losses is allocated to certain loan categories based on
the relative risk characteristics, asset classifications, and actual loss
experience of the loan portfolio. Although management has allocated the
allowance for loan losses to various loan portfolio segments, the allowance is
general in nature and is available to the loan portfolio in its
entirety.





62








SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements






The
ultimate recovery of all loans is susceptible to future market factors beyond
the Company’s control. These factors may result in losses or recoveries
differing significantly from those provided in the consolidated financial
statements. In addition, regulatory agencies, as an integral part of their
examination process, periodically review the Company’s allowance for credit
losses, and may require the Company to make additions to the allowance based on
their judgment about information available to them at the time of their
examinations.




Transfers of financial assets
- Transfers of financial assets are accounted for as sales when control over the
assets has been surrendered. Control over transferred assets is deemed to be
surrendered when: (1) the assets have been isolated from the Company, (2) the
transferee obtains the right (free of conditions that constrain it from taking
advantage of that right) to pledge or exchange the transferred assets, and (3)
the Company does not maintain effective control over the transferred assets
through an agreement to repurchase them before their maturity.




Mortgage servicing rights -
The Company generally retains the right to service mortgage loans sold to
others. The cost allocated to the mortgage servicing rights retained has been
recognized as a separate asset and is being amortized in proportion to, and over
the period of, estimated net servicing income.





The
Company acquired certain mortgage servicing rights through a purchase
transaction and has elected to mark the mortgage servicing rights to market
using the fair value option. Purchased mortgage servicing rights marked to
market are presented separately on the balance sheet from the originated
mortgage servicing rights, which are held at the lower of cost or market and are
periodically evaluated for impairment based upon the fair value of those
rights.





Fair values are
estimated using discounted cash flows based upon current market rates of
interest and current expected future prepayment rates. For purposes of measuring
impairment, the rights must be stratified by one or more predominant risk
characteristics of the underlying loans. The Company stratifies its capitalized
mortgage servicing rights based on the type, term, and interest rate of the
underlying loans. The amount of impairment recognized is the amount, if any, by
which the amortized cost of the rights for each stratum exceeds their fair
value.




Premises and equipment -
Leasehold improvements and furniture and equipment are carried at cost, less
accumulated depreciation and amortization. Furniture and equipment are
depreciated using the straight-line method over the estimated useful lives of
the assets, which range from 1 to 10 years. The cost of leasehold improvements
is amortized using the straight-line method over the terms of the related
leases.




Cash surrender value of bank owned
life insurance - The carrying amount of bank owned life insurance
approximates its fair value, and is estimated using the cash surrender value,
net of any surrender charges.




Federal Home Loan Bank stock –
The Bank is a member of the Federal Home Loan Bank of Seattle
(“FHLB”).  FHLB stock represents the Company’s investment in the FHLB
and is carried at par value, which reasonably approximates its fair value. As a
member of the FHLB system, the Company is required to maintain a minimum level
of investment in FHLB stock based on specific percentages of its outstanding
mortgages, total assets, or FHLB advances. At December 31, 2009, the Company’s
minimum required investment in FHLB stock was $868,000. Typically the Company
may request redemption at par value of any stock in excess of the minimum
required investment. Stock redemptions are at the discretion of the
FHLB.








63








SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements







Due to ongoing turmoil in the capital
and mortgage markets, the FHLB has a risk-based capital deficiency largely a
result of write-downs on its private label mortgage-backed securities
portfolios. The Company evaluates FHLB stock for impairment. The determination
of whether these investments are impaired is based on their assessment of the
ultimate recoverability of cost rather than by recognizing temporary declines in
value. The determination of whether a decline affects the ultimate
recoverability of cost is influenced by criteria such as (1) the significance of
any decline in net assets of the FHLB as compared to the capital stock amount
for the FHLB and the length of time this situation has persisted; (2)
commitments by the FHLB to make payments required by law or regulation and the
level of such payments in relation to the operating performance of the FHLB; (3)
the impact of legislative and regulatory changes on institutions and,
accordingly, the customer base of the FHLB; and (4) the liquidity position of
the FHLB.




Under
Federal Housing Finance Agency regulations, a Federal Home Loan Bank that fails
to meet any regulatory capital requirement may not declare a dividend or redeem
or repurchase capital stock in excess of what is required for members’ current
loans. Based on an analysis by Standard and Poor’s regarding the Federal Home
Loan Banks, the FHLB system has a special public status (organized under the
Federal Home Loan Bank Act of 1932), and because of the extraordinary support
offered to it by the U.S. Treasury in a crisis (though not used), it can be
considered an extension of the government. The U.S. government would almost
certainly support the credit obligations of the FHLB system. Based on the above,
the Company has determined there is not an OTTI on the FHLB stock investment as
of December 31, 2009.





Other real estate owned and
repossessed assets -Other real estate owned and repossessed assets
represent real estate and other assets which the Company has taken control of in
partial or full satisfaction of loans. At the time of foreclosure or
repossession, other real estate owned and repossessed assets are recorded at the
lower of the carrying amount of the loan or fair value less costs to sell, which
becomes the new basis. Any write-downs based on the asset’s fair value at the
date of acquisition are charged to the allowance for loan and lease losses.
After foreclosure or repossession, management periodically performs valuations
such that the property is carried at the lower of its new cost basis or fair
value, net of estimated costs to sell. Subsequent valuation adjustments are
recognized within net (loss) gain on other real estate owned. Revenue and
expenses from operations and subsequent adjustments to the carrying amount of
the property are included in other non-interest expense in the consolidated
statements of operations.




In some
instances, the Company may make loans to facilitate the sales of other real
estate owned. Management reviews all sales for which it is the lending
institution.  Any gains related to sales of other real estate owned
may be deferred until the buyer has a sufficient initial and continuing
investment in the property.





Income Taxes -Income taxes
are accounted for using the asset and liability method. Under this method a
deferred tax asset or liability is determined based on the enacted tax rates
which will be in effect when the differences between the financial statement
carrying amounts and tax basis of existing assets and liabilities are expected
to be reported in the Company’s income tax returns. The effect on deferred taxes
of a change in tax rates is recognized in income in the period that includes the
enactment date.





Valuation
allowances are established to reduce the net carrying amount of deferred tax
assets if it is determined to be more likely than not, that all or some portion
of the potential deferred tax asset will not be realized.














64








SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements




Deposits – At December 31,
2009 and 2008, deposits represent various accounts of the owners of the Company.
Deposit ownership entitles the members to vote in the annual elections of the
board of directors and on other corporate matters. Members are permitted to cast
one vote for each $100, or fraction thereof, of the withdrawal value of the
members’ accounts up to a maximum of 1,000 votes. Members’ deposits are
subordinated to all other liabilities of the Company upon liquidation. Interest
on members’ deposits is based on available earnings at the end of an interest
period and is not guaranteed by the Company. Interest rates are set by the
Company’s Asset-Liability Management Committee.





Segment reporting - The
Company operates in one segment and makes management decisions based on
consolidated results. The Company’s operations are solely in the financial
services industry and include providing to its customers traditional banking and
other financial services.





Off-balance-sheet credit-related
financial instruments-In the normal course of
operations, the Company engages in a variety of financial transactions that are
not recorded in our financial statements.  These transactions involve
varying degrees of off-balance sheet credit, interest rate and liquidity
risks.  These transactions are used primarily to manage customers’
requests for funding and take the form of loan commitments, letters of credit
and lines of credit.  Such financial instruments are recorded when
they are funded.





Advertising costs - The
Company expenses advertising costs as they are incurred. Advertising expenses
were $300,000 and $230,000, respectively for the years ended December 31, 2009
and 2008.





Comprehensive loss -
Accounting principles generally require that recognized revenue, expenses,
gains, and losses be included in net income (loss). Certain changes in assets
and liabilities, such as unrealized gains and losses on available-for-sale
investments, are reported as a separate component of the equity section of the
balance sheet. Such items, along with net income (loss), are components of
comprehensive loss.





Intangible Assets -At
December 31, 2009, we had $1.1 million of identifiable intangible assets
included in other assets as a result of the acquisition of deposits from another
institution.  This asset is amortized using the straight-line method
over a period of 9.5 years.

















65





SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements




The
components of other comprehensive loss and related tax effects are as
follows:




2009
            
            
            2008Reclassification
      adjustment for realized gainon
      sale of available-for-sale securities
              and impairment on securities
            
            $
            211,625
            
            
            $
            -Unrealized
      holding loss on available-for-sale
      securities
            
            $
            (434,348
            )
            
            $
            (1,204,005
            )Net
      unrealized losses
            
            
            (222,723
            )
            
            
            (1,204,005
            )Tax
      benefit
            
            
            75,726
            
            
            
            408,287Net-of-tax
      amount
            
            $
            (146,997
            )
            
            $
            (795,718
            )







The components of accumulated other
comprehensive (loss) and related tax effects are as follows:




2009
            
            
            2008Net
      unrealized loss onavailable-for-sale
      securities
            
            $
            (1,423,568
            )
            
            $
            (1,200,844
            )Tax
      benefit
            
            
            484,014
            
            
            
            408,287Net-of-tax
      amount
            
            $
            (939,554
            )
            
            $
            (792,557
            )





Employee stock ownership plan
- The Company sponsors a leveraged ESOP. As shares are committed to be released,
compensation expense is recorded equal to the market price of the shares, and
the shares become outstanding for purposes of earnings per share calculations.
Cash dividends on allocated shares (those credited to ESOP participants’
accounts) are recorded as a reduction of retained earnings and distributed
directly to participants’ accounts. Cash dividends on unallocated shares (those
held by the ESOP not yet credited to participants’ accounts) are used to pay
administrative expenses and debt service requirements of the ESOP.  At
December 31, 2009, there were 92,448 unallocated shares in the
plan.  Shares released on December 31, 2009 totaled 11,556 and will be
credited to plan participants’ accounts in 2010 (see Note 11).





(Loss) earnings per share -Basic (loss) earnings per share is net (loss) income divided by the
weighted average number of common shares outstanding during the periods, which
was 2,903,798 and 2,838,410 shares for the years ended December 31, 2009 and
2008.  ESOP shares are considered dilutive and outstanding for this
calculation, unless unearned.  There are currently no potentially
dilutive common shares issuable under stock options or other
programs.  Common stock equivalent shares include the stock options
and restricted stock awards under the 2008 Employee Stock Ownership Plan
approved by the shareholders in January 2008.





Fair value -Fair value is
defined as the price that would be received to sell an asset or paid to transfer
a liability (the “exit price”) in an orderly transaction between market
participants at the measurement date. Fair value is a market-based measure
considered from the perspective of a market participant who holds the asset or
owes the liability rather than an entity-specific measure.





A
three-level hierarchy was established for disclosure of assets and liabilities
recorded at fair value. The classification of assets and liabilities within the
hierarchy is based on whether the inputs to the valuation methodology used for
measurement are observable or unobservable. Observable inputs reflect
market-derived or market-based information obtained from independent sources,
while unobservable inputs reflect our estimates about market data. The three
levels for measuring fair value are based on the reliability of inputs and are
as follows:





66





SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements




Level 1 –
Valuations based on quoted prices in active markets for identical assets or
liabilities that we have the ability to access. Valuation adjustments and block
discounts are not applied to instruments utilizing Level 1 inputs. Since
valuations are based on quoted prices that are readily and regularly available
in an active market, valuation of these products does not entail a significant
degree of judgment. Assets utilizing Level 1 inputs include exchange-traded
equity securities.





Level 2 –
Valuations based on quoted prices in markets that are not active or for which
all significant inputs are observable, directly or indirectly. Assets and
liabilities utilizing Level 2 inputs include U.S. treasury and agency
securities, mortgage-backed securities and municipal bonds.





Level 3 –
Valuations based on inputs that are unobservable and significant to the overall
fair value measurement. Assets utilizing Level 3 inputs include impaired loans
and other real estate owned.





To the
extent that valuation is based on models or inputs that are less observable or
unobservable in the market, the determination of fair value requires more
judgment. Accordingly, the degree of judgment that we use to determine fair
value is greatest for instruments categorized in Level 3. In certain cases, the
inputs used to measure fair value may fall into different levels of the fair
value hierarchy. In such cases, for disclosure purposes the level in the fair
value hierarchy within which the fair value measurement in its entirety falls is
determined based on the lowest level input that is significant to the fair value
measurement in its entirety.





Fair
value measurements for assets and liabilities where there exists limited or no
observable market data and, therefore, are based primarily upon our own
estimates, are often calculated based on current pricing policy, the economic
and competitive environment, the characteristics of the asset or liability and
other such factors. Therefore, the results cannot be determined with precision
and may not be realized in an actual sale or immediate settlement of the asset
or liability. Additionally, there may be inherent weaknesses in any calculation
technique and changes in the underlying assumptions used, including discount
rates and estimates of future cash flows, that could significantly affect the
results of current or future values.





Subsequent events- Subsequent
events are events or transactions that occur after the date of the statement of
financial condition but before financial statements are issued. Recognized
subsequent events are events or transactions that provide additional evidence
about conditions that existed at the date of the statement of financial
condition, including the estimates inherent in the process of preparing
financial statements. Nonrecognized subsequent events are events that provide
evidence about conditions that did not exist at the date of the statement of
financial condition but arose after that date.





Reclassifications -Certain
amounts reported in prior years’ and quarters’ financial statements have been
reclassified to conform to the current presentation. The results of the
reclassifications are not considered material and have no effect on previously
reported net income and earnings per share.





Note
2 – Accounting Pronouncements Recently Issued or Adopted




On
July 1, 2009, the Accounting Standards Codification became FASB’s
officially recognized source of authoritative U.S. generally accepted accounting
principles applicable to all public and non-public non-governmental entities,
superseding existing FASB, AICPA, EITF and related literature. Rules and
interpretive releases of the SEC under the authority of federal securities laws
are also sources of authoritative GAAP for SEC registrants. All other accounting
literature is considered non-authoritative.




The
switch to the ASC affects the way companies refer to U.S. GAAP in financial
statements and accounting policies. Citing particular content in the ASC
involves specifying the unique numeric path to the content through the Topic,
Subtopic, Section and Paragraph structure.








67





SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements




FASB ASC
Topic 260, “Earnings Per Share.”  On
January 1, 2009, the Company adopted new authoritative accounting guidance
under ASC Topic 260, “Earnings Per Share,” which provides that unvested
share-based payment awards that contain non-forfeitable rights to dividends or
dividend equivalents (whether paid or unpaid) are participating securities and
shall be included in the computation of earnings per share pursuant to the
two-class method. Adoption of the new guidance did not significantly impact the
Company’s financial statements.





FASB ASC
Topic 320, “Investments—Debt and Equity Securities.”  New
authoritative accounting guidance under ASC Topic 320, “Investments—Debt and
Equity Securities,” (i) changes existing guidance for determining whether an
impairment is other than temporary to debt securities and (ii) replaces the
existing requirement that the entity’s management assert it has both the intent
and ability to hold an impaired security until recovery with a requirement that
management assert: (a) it does not have the intent to sell the security; and (b)
it is more likely than not it will not have to sell the security before recovery
of its cost basis. Under ASC Topic 320, declines in the fair value of
held-to-maturity and available-for-sale securities below their cost that are
deemed to be other than temporary are reflected in earnings as realized losses
to the extent the impairment is related to credit losses. The amount of the
impairment related to other factors is recognized in other comprehensive income.
The Company’s adopted the provisions of the new authoritative accounting
guidance under ASC Topic 320 during the first quarter of 2009. Adoption of the
new guidance did not significantly impact the Company’s financial
statements.




FASB ASC
Topic 715, “Compensation—Retirement Benefits.” New authoritative
accounting guidance under ASC Topic 715, “Compensation—Retirement Benefits,”
provides guidance related to an employer’s disclosures about plan assets of
defined benefit pension or other post-retirement benefit plans. Under ASC Topic
715, disclosures should provide users of financial statements with an
understanding of how investment allocation decisions are made, the factors that
are pertinent to an understanding of investment policies and strategies, the
major categories of plan assets, the inputs and valuation techniques used to
measure the fair value of plan assets, the effect of fair value measurements
using significant  unobservable inputs on changes in plan assets for
the period and significant concentrations of risk within plan assets. The new
authoritative accounting guidance under ASC Topic 715 became effective for the
Company’s financial statements for the year-ended December 31, 2009.
Adoption of the new guidance did not significantly impact the Company’s
financial statements.





FASB ASC
Topic 805, “Business Combinations.” On January 1, 2009, new
authoritative accounting guidance under ASC Topic 805, “Business Combinations,”
became applicable to the Corporation’s accounting for business combinations
closing on or after January 1, 2009. ASC Topic 805 applies to all transactions
and other events in which one entity obtains control over one or more other
businesses. ASC Topic 805 requires an acquirer, upon initially obtaining control
of another entity, to recognize the assets, liabilities and any non-controlling
interest in the acquiree at fair value as of the acquisition date. Contingent
consideration is required to be recognized and measured at fair value on the
date of acquisition rather than at a later date when the amount of that
consideration may be determinable beyond a reasonable doubt. This fair value
approach replaces the cost-allocation process required under previous accounting
guidance whereby the cost of an acquisition was allocated to the individual
assets acquired and liabilities assumed based on their estimated fair value. ASC
Topic 805 requires acquirers to expense acquisition-related costs as incurred
rather than allocating such costs to the assets acquired and liabilities
assumed, as was previously the case under prior accounting guidance. Assets
acquired and liabilities assumed in a business combination that arise from
contingencies are to be recognized at fair value if fair value can be reasonably
estimated. If fair value of such an asset or liability cannot be reasonably
estimated, the asset or liability would generally be recognized in accordance
with ASC Topic 450, “Contingencies.” Under ASC Topic 805, the requirements of
ASC Topic 420, “Exit or Disposal Cost Obligations,” would have to be met in
order to accrue for a restructuring plan in purchase accounting.





68





SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements




Pre-acquisition
contingencies are to be recognized at fair value, unless it is a non-contractual
contingency that is not likely to materialize, in which case, nothing should be
recognized in purchase accounting and, instead, that contingency would be
subject to the probable and estimable recognition criteria of ASC Topic 450,
“Contingencies.”  The branch acquisitions in Note 18 were accounted
for as a business combination in accordance with ASC Topic 805.




FASB ASC
Topic 810, “Consolidation.” New authoritative
accounting guidance under ASC Topic 810, “Consolidation,” amended prior guidance
to establish accounting and reporting standards for the non-controlling interest
in a subsidiary and for the deconsolidation of a subsidiary. Under ASC Topic
810, a non-controlling interest in a subsidiary, which is sometimes referred to
as minority interest, is an ownership interest in the consolidated entity that
should be reported as a component of equity in the consolidated financial
statements. Among other requirements, ASC Topic 810 requires consolidated
net income to be reported at amounts that include the amounts attributable to
both the parent and the non-controlling interest. It also requires disclosure,
on the face of the consolidated income statement, of the amounts of consolidated
net income attributable to the parent and to the non-controlling interest. The
new authoritative accounting guidance under ASC Topic 810 became effective
for the Company on January 1, 2009 and did not have a significant impact on the
Company’s financial statements.




Further
new authoritative accounting guidance under ASC Topic 810 amends prior guidance
to change how a Company determines when an entity that is insufficiently
capitalized or is not controlled through voting (or similar rights) should be
consolidated. The determination of whether a Company is required to consolidate
an entity is based on, among other things, an entity’s purpose and design and a
Company’s ability to direct the activities of the entity that most significantly
impact the entity’s economic performance. The new authoritative accounting
guidance requires additional disclosures about the reporting entity’s
involvement with variable-interest entities and any significant changes in risk
exposure due to that involvement as well as its affect on the entity’s financial
statements. The new authoritative accounting guidance under ASC Topic 810 will
be effective January 1, 2010 and is not expected to have a significant impact on
the Company’s financial statements.




FASB ASC
Topic 815, “Derivatives and Hedging.” New authoritative
accounting guidance under ASC Topic 815, “Derivatives and Hedging,” amends prior
guidance to amend and expand the disclosure requirements for derivatives and
hedging activities to provide greater transparency about (i) how and why an
entity uses derivative instruments, (ii) how derivative instruments and related
hedge items are accounted for under ASC Topic 815, and (iii) how derivative
instruments and related hedged items affect an entity’s financial position,
results of operations and cash flows. To meet those objectives, the new
authoritative accounting guidance requires qualitative disclosures about
objectives and strategies for using derivatives, quantitative disclosures about
fair value amounts of gains and losses on derivative instruments and disclosures
about credit-risk-related contingent features in derivative agreements. The new
authoritative accounting guidance under ASC Topic 815 became effective for the
Company on January 1, 2009. Adoption of the new guidance did not significantly
impact the Company’s financial statements.





FASB ASC
Topic 820, “Fair Value Measurements and Disclosures.” ASC Topic 820, Fair Value
Measurements and Disclosures, defines fair value, establishes a framework for
measuring fair value in generally accepted accounting principles, and expands
disclosures about fair value measurements.  Additional new
authoritative accounting guidance under ASC Topic 820 affirms that the objective
of fair value when the market for an asset is not active is the price that would
be received to sell the asset in an orderly transaction, and clarifies and
includes additional factors for determining whether there has been a significant
decrease in market activity for an asset when the market for that asset is not
active. ASC Topic 820 requires an entity to base its conclusion about whether a
transaction was not orderly on the weight of the evidence. The new accounting
guidance amended prior guidance to expand certain disclosure
requirements.








69





SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements




Further
new authoritative accounting guidance (Accounting Standards Update No. 2009-5)
under ASC Topic 820 provides guidance for measuring the fair value of a
liability in circumstances in which a quoted price in an active market for the
identical liability is not available. In such instances, a reporting entity is
required to measure fair value utilizing a valuation technique that uses (i) the
quoted price of the identical liability when traded as an asset, (ii) quoted
prices for similar liabilities or similar liabilities when traded as assets, or
(iii) another valuation technique that is consistent with the existing
principles of ASC Topic 820, such as an income approach or market approach. The
new authoritative accounting guidance also clarifies that when estimating the
fair value of a liability, a reporting entity is not required to include a
separate input or adjustment to other inputs relating to the existence of a
restriction that prevents the transfer of the liability. The forgoing new
authoritative accounting guidance under ASC Topic 820 became effective for the
Company’s financial statements for periods ending after June 15, 2009 and did
not have a significant impact on the Company’s financial
statements.




FASB ASC
Topic 855, “Subsequent Events.” New authoritative
accounting guidance under ASC Topic 855, “Subsequent Events,” establishes
general standards of accounting for and disclosure of events that occur after
the balance sheet date but before financial statements are issued or available
to be issued. ASC Topic 855 defines (i) the period after the balance sheet date
during which a reporting entity’s management should evaluate events or
transactions that may occur for potential recognition or disclosure in the
financial statements, (ii) the circumstances under which an entity should
recognize events or transactions occurring after the balance sheet date in its
financial statements, and (iii) the disclosures an entity should make about
events or transactions that occurred after the balance sheet date. The new
authoritative accounting guidance under ASC Topic 855 became effective for the
Company’s financial statements for periods ending after June 15, 2009 and did
not have a significant impact on the Company’s financial
statements.





FASB ASC
Topic 860, “Transfers and Servicing.” New authoritative
accounting guidance under ASC Topic 860, “Transfers and Servicing,” amends prior
accounting guidance to enhance reporting about transfers of financial assets,
including securitizations, and where companies have continuing exposure to the
risks related to transferred financial assets. The new authoritative accounting
guidance eliminates the concept of a “qualifying special-purpose entity” and
changes the requirements for derecognizing financial assets. The new
authoritative accounting guidance also requires additional disclosures about all
continuing involvements with transferred financial assets including information
about gains and losses resulting from transfers during the period. The new
authoritative accounting guidance under ASC Topic 860 will be effective
January 1, 2010.  Management is currently evaluating the impact
of adoption on the Company’s consolidated financial statements.




Note
3 – Cash and due from banks




Federal Reserve Board regulations
require that the Company maintain certain minimum reserve balances either as
cash on hand or on deposit with the Federal Reserve Bank, based on a percentage
of deposits. The reserve balances were $25,000 at December 31, 2009 and 2008,
respectively.







70







SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements






Note
4 – Investments




The amortized cost and fair value of
our AFS securities and the corresponding amounts of gross unrealized gains and
losses were as follows:


Gross
      Unrealized
              
              
              EstimatedAmortized
              
              
              
              
              
              Losses
      Less
              
              
              Losses
      Greater
              
              
              FairCost
              
              
              Gains
              
              
              Than
      1 Year
              
              
              Than
      1 Year
              
              
              ValueDecember
      31, 2009Agency
      mortgage-backed
                securities
              
              $
              3,421,392
              
              
              $
              5,415
              
              
              $
              (57,076
              )
              
              $
              -
              
              
              $
              3,369,731Non-agency
      mortgage-backed securities
              
              
              7,901,268
              
              
              
              120,866
              
              
              
              -
              
              
              
              (1,492,773
              )
              
              
              6,529,361Total
      AFS Investments
              
              $
              11,322,660
              
              
              $
              126,281
              
              
              $
              (57,076
              )
              
              $
              (1,492,773
              )
              
              $
              9,899,092December
      31, 2008Agency
      mortgage-backed
                securities
              
              $
              2,007,166
              
              
              $
              21,596
              
              
              $
              -
              
              
              $
              -
              
              
              $
              2,028,762Non-agency
      mortgage-backed securities
              
              
              8,123,476
              
              
              
              -
              
              
              
              (1,222,440
              )
              
              
              -
              
              
              
              6,901,036Total
      AFS Investments
              
              $
              10,130,642
              
              
              $
              21,596
              
              
              $
              (1,222,440
              )
              
              $
              -
              
              
              $
              8,929,798





There are 7
securities in an unrealized loss position greater than 1 year as of December 31,
2009. The unrealized losses on investments in U.S. agency securities were caused
by interest rate increases subsequent to the purchase of these securities. The
contractual terms of these investments do not permit the issuer to settle the
securities at a price less than par. Because the Bank does not intend to sell
the securities in this class and it is not likely that the Bank will be required
to sell these securities before recovery of their amortized cost bases, which
may include holding each security until contractual maturity, the unrealized
losses on these investments are not considered other-than-temporarily
impaired.





We review investment securities on an
ongoing basis for the presence of other-than-temporary (“OTTI”) or permanent
impairment, taking into consideration current market conditions, fair value in
relationship to cost, extent and nature of the change in fair value, issuer
rating changes and trends, whether we intend to sell a security or if it is
likely that we will be required to sell the security before recovery of our
amortized cost basis of the investment, which may be maturity, and other
factors.  For debt securities, if we intend to sell the security or it
is likely that we will be required to sell the security before recovering its
cost basis, the entire impairment loss would be recognized in earnings as an
OTTI.





If we do
not intend to sell the security and it is not likely that we will be required to
sell the security but we do not expect to recover the entire amortized cost
basis of the security, only the portion of the impairment loss representing
credit losses would be recognized in earnings.  The credit loss on a
security is measured as the difference between the amortized cost basis and the
present value of the cash flows expected to be collected.





Projected
cash flows are discounted by the original or current effective interest rate
depending on the nature of the security being measured for potential
OTTI.  The remaining impairment related to all other factors, the
difference between the present value of the cash flows expected to be collected
and the fair value, is recognized as a charge to other comprehensive income
(“OCI”).  Impairment losses related to all other factors are presented
as separate categories within OCI.





71










SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements




During
the year ended December 31, 2009, we recognized a $61,000 non-cash other than
temporary impairment (“OTTI”) charge on two non-agency mortgage-backed
securities.  At December 31, 2009, the fair value of these two securities
were $1.3 million.  Management concluded that the decline of the estimated
fair value below the cost of the securities was other than temporary and
recorded a credit loss of $61,000 through non-interest income.  We
determined the remaining decline in value of $440,000 was not related to
specific credit deterioration.  We do not intend to sell these securities
and it is more likely than not that we will be required to sell the securities
before anticipated recovery of the remaining amortized cost basis.  We
closely monitor our investment securities for changes in credit risk.  The
current market environment significantly limits our ability to mitigate our
exposure to valuation changes in these securities by selling them. 
Accordingly, if market conditions deteriorate further and we determine our
holdings of these or other investment securities are OTTI, our future earnings,
shareholders’ equity, regulatory capital and continuing operations could be
materially adversely affected.





There was
no beginning balance of credit losses.  Additions to credit losses in
2009 were $61,000.  There were no reductions in credit losses due to
sales in 2009.





New
guidance related to the recognition and presentation of OTTI of debt securities
became effective beginning in the second quarter of 2009. Rather than asserting
whether a Company has the ability and intent to hold an investment until a
market price recovery, a Company must consider whether they intend to sell a
security or if it is likely that they would be required to sell the security
before recovery of the amortized cost basis of the investment, which may be
maturity. The $61,000 in OTTI recognized on investment securities as primarily
relates to two non-agency residential mortgage backed securities. Each of these
securities holds various levels of credit subordination. These securities are
valued by third-party pricing services using matrix or model pricing
methodologies and were corroborated by broker indicative bids. We estimate cash
flows of the underlying collateral for each security considering credit,
interest and prepayment risk models that incorporate management’s estimate of
projected key assumptions including prepayment rates, collateral default rates
and loss severity.





We review
the actual collateral performance of these securities to support our estimation
of the projected key assumptions utilized to determine future estimated cash
flows. Assumptions utilized vary from security to security, and are influenced
by factors such as loan interest rates, geographic location, borrower
characteristics and vintage, and historical experience. We then used a third
party to obtain information about the structure of each security, including
subordination and other credit enhancements, in order to determine how the
underlying collateral cash flows will be distributed to each security issued in
the structure. These cash flows are then discounted at the interest rate used to
recognize interest income on each security. The following presents a summary of
the significant inputs utilized to measure management’s estimate of the credit
loss component on these non-agency residential mortgage backed securities as of
December 31, 2009. For these two securities, we considered a constant repayment
rate range between 6.75% and 8.69%, a collateral default rate between 26.31% and
31.51% and a loss severity rate between 39% and 51%.





2009
            
            
            2008(Loss)
      gain on investment securities, netGain
      on sale of investment securities
            
            $
            272,845
            
            
            $
            153,633Total
      other than temporary impairment losses
            
            
            (501,489
            )
            
            
            -Portion
      of other than temporary lossesrecognized
      in other comprehensive income
            
            
            440,269
            
            
            
            -Total
      (loss) gain on securities, net
            
            $
            211,625
            
            
            $
            153,633





72







SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements




The
amortized cost and fair value of mortgage-backed securities by contractual
maturity, at December 31, 2009, are shown below.  Expected maturities
of mortgage-backed securities may differ from contractual maturities because
borrowers may have the right to call or prepay obligations with or without call
or prepayment penalties.




December
      31, 2009Amortized
      Cost
              
              
              Fair
      Value(In
      thousands)Due
      within one year
              
              $
              -
              
              
              $
              -Due
      after one year through five years
              
              
              -
              
              
              
              -Due
      after five years through ten years
              
              
              -
              
              
              
              -Due
      after ten years
              
              
              11,322,660
              
              
              
              9,899,092$
              11,322,660
              
              
              $
              9,899,092





Proceeds from the sale of securities
were $29.9 million for the period ended December 31, 2009 with gross gains of
$401,000 and gross losses of $128,000.  There were no sales of
securities in 2008.





Securities with an amortized cost of
$2.2 million and $2.0 million and a fair value of $2.1 million and $2.0 million
at December 31, 2009 and 2008, respectively, were pledged to secure Washington
State Public Funds. Securities with an amortized cost of $693,000 and $2.0
million and a fair value of $626,000 and $2.0 million at December 31, 2009 and
2008, respectively, were pledged as collateral to the FHLB of
Seattle.





73





SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements




Note
5 - Loans




The composition of the loan portfolio,
excluding loans held for sale, was as follows:




December
      31,2009
              
              
              2008
              
              
              Percentage
      Increase/ (Decrease)Real
      estate loansOne-
      to four-family
              
              $
              104,460,367
              
              
              $
              89,907,581
              
              
              
              16.2
              %Home
      equity
              
              
              50,444,530
              
              
              
              54,556,779
              
              
              
              (7.5
              %)Commercial
              
              
              72,035,266
              
              
              
              48,729,582
              
              
              
              47.8
              %Construction
      or development
              
              
              10,000,289
              
              
              
              12,220,170
              
              
              
              (18.2
              %)236,940,452
              
              
              
              205,414,112
              
              
              
              15.3
              %Consumer
      loansManufactured
      homes
              
              
              21,472,799
              
              
              
              22,722,664
              
              
              
              (5.5
              %)Automobile
              
              
              6,445,829
              
              
              
              10,079,522
              
              
              
              (36.1
              %)Other
              
              
              7,499,180
              
              
              
              7,871,022
              
              
              
              (4.7
              %)35,417,808
              
              
              
              40,673,208
              
              
              
              (12.9
              %)Commercial
      business loans
              
              
              17,799,946
              
              
              
              17,667,965
              
              
              
              0.7
              %Total
      loans
              
              
              290,158,206
              
              
              
              263,755,285
              
              
              
              10.0
              %Deferred
      loan origination fees
              
              
              (334,073
              )
              
              
              (42,488
              )
              
              
              686.3
              %Allowance
      for loan losses
              
              
              (3,467,567
              )
              
              
              (1,305,950
              )
              
              
              165.5
              %Total
      loans, net
              
              $
              286,356,566
              
              
              $
              262,406,847
              
              
              
              9.1
              %




The following is an analysis of the
change in the allowance for loan losses:




Twelve
      Months Ended December 31,2009
            
            
            2008Balance,
      beginning of year
            
            $
            1,305,950
            
            
            $
            827,688Provision
      for loan losses
            
            
            4,275,000
            
            
            
            1,110,000Recoveries
            
            
            159,089
            
            
            
            159,351Charge-offs
            
            
            (2,272,472
            )
            
            
            (791,089
            )Balance,
      end of year
            
            $
            3,467,567
            
            
            $
            1,305,950





A summary
of nonaccrual, impaired and troubled debt restructured loans are as
follows:




December
      31,2009
              
              
              2008Impaired
      loans with a valuation allowance
              
              $
              4,125,169
              
              
              $
              1,610,455Valuation
      allowance related to impaired loans
              
              
              (1,424,270
              )
              
              
              (581,177
              )Impaired
      loans without a valuation allowance
              
              
              9,019,027
              
              
              
              2,996,545Total
      impaired loans, net of valuation allowance for impaired
    loans
              
              $
              11,719,926
              
              
              $
              4,025,823Total
      loans past due 90-days or more and still accruing interest
              
              $
              -
              
              
              $
              -Total
      non-accrual loans
              
              
              3,607,000
              
              
              
              1,252,000Average
      investment in impaired loans
              
              
              11,385,000
              
              
              
              4,041,000Interest
      income recognized on impaired loans
              
              
              -
              
              
              
              -Troubled
      debt restructured loans
              
              
              7,424,000
              
              
              
              550,000Troubled
      debt restructured loans included in impaired loans
              
              $
              7,424,000
              
              
              $
              550,000





74











SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements




The non-accrual loans at December 31,
2009 consisted of $1.2 million in commercial real estate loans, $1.5 million in
one- to four- family mortgage loans, $791,000 in home equity loans, $111,000 in
commercial business loans and $17,000 in consumer loans. The Company does not
accrue interest on loans past due 90 days or more.  Forgone interest
on nonaccrual loans for the year ended December 31, 2009 was
$203,000.  At December 31, 2009, there were no commitments to lend
additional funds to borrowers whose loans were classified as non-accrual or
impaired.





The
non-accrual loans at December 31, 2008 consisted of $471,000 in commercial real
estate loans, $258,000 in one- to four-family mortgage loans, $340,000 in home
equity loans, $59,000 in construction loans, $63,000 in consumer loans and
$61,000 in commercial business loans.  The Company does not accrue
interest on loans past due 90 days or more.  Forgone interest on
nonaccrual loans for the year ended December 31, 2008 was $56,000.  At
December 31, 2008, there were no commitments to lend additional funds to
borrowers whose loans were classified as non-accrual or impaired.





As a result of new or continuing
delinquencies and ongoing credit evaluations during the period subsequent to
December 31, 2009, $1.7 million of additional loans were added to nonaccrual
status and $2.4 million of additional loans were subject to troubled debt
restructurings.





In the ordinary course of business, the
Company makes loans to its directors and officers. Certain loans to directors,
officers, and employees are offered at discounted rates as compared to other
customers as permitted by federal regulations. Employees, officers, and
directors are eligible for mortgage loans with an adjustable rate that resets
annually to 1% over the rolling cost of funds. Employees and officers are
eligible for consumer loans that are 1% below the market loan rate at the time
of origination. Loans to directors and officers at December 31, 2009 and 2008
totaled approximately $7.4 million and $5.1 million, respectively. During 2009,
loan advances and repayments totaled approximately $2.5 million and $200,000
respectively, on these loans. During 2008, loan advances and repayments totaled
approximately $1.3 million and $1.6 million, respectively, on these
loans.




At
December 31, 2009 and 2008, respectively, loans totaling $3.3 million and $2.4
million represent real estate secured loans that have loan-to-value ratios above
supervisory guidelines.




Note
6 – Loan Servicing




The unpaid principal balances of loans
serviced for Federal National Mortgage Association (FNMA) at December 31, 2009
and 2008, totaled approximately $510.9 million and $141.5 million, respectively,
and are not included in the Company’s financial statements.




A summary of the change in the balance
of mortgage servicing assets is as follows:




2009
            
            
            2008Balance,
      beginning of year
            
            $
            863,146
            
            
            $
            864,946Servicing
      assets recognized during the year
            
            
            893,112
            
            
            
            396,934Amortization
      of servicing assets
            
            
            (475,220
            )
            
            
            (341,608
            )Fair
      value adjustment
            
            
            124,618
            
            
            
            (57,126
            )Purchase
      of third party servicing portfolio
            
            
            1,921,642
            
            
            
            -Balance,
      end of year
            
            $
            3,327,298
            
            
            $
            863,146







On November 30, 2009, the Company
acquired a $339 million loan servicing portfolio from Leader Financial
Services.  These loans are 100% owned by Fannie Mae and are
subserviced under an agreement
with a third party loan servicer who performs all servicing including payment
processing, reporting and collections.






75






SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements




The key economic assumptions used in
determining the fair value of mortgage servicing rights are as
follows:




2009
            
            
            2008Prepayment
      speed (PSA)
            
            
            287
            %
            
            
            381
            %Weighted-average
      life (years)
            
            
            4.3
            
            
            
            3.2Yield
      to maturity discount rate
            
            
            9.0
            %
            
            
            9.0
            %




Note
7 – Premises and Equipment




Premises
and equipment are summarized as follows:




2009
            
            
            2008Land
            
            $
            350,000
            
            
            $
            -Buildings
            
            
            402,256
            
            
            
            -Leasehold
      improvements
            
            
            2,789,511
            
            
            
            1,831,776Furniture
      and equipment
            
            
            1,084,001
            
            
            
            1,927,0944,625,768
            
            
            
            3,758,870Accumulated
      depreciation and amortization
            
            
            (1,102,015
            )
            
            
            (2,222,128
            )3,523,753
            
            
            
            1,536,742Fixed
      assets in process
            
            
            -
            
            
            
            8,963$
            3,523,753
            
            
            $
            1,545,705





Depreciation and amortization expense
for the years ended December 31, 2009 and 2008 amounted to $492,000 and $404,000
respectively.




The Company leases office space in
several buildings. Generally, operating leases contain renewal options and
provisions requiring the Company to pay property taxes and operating expenses
over base period amounts. All rental payments are dependent only upon the lapse
of time.




Minimum rental payments under
non-cancelable operating leases with initial or remaining terms of one year or
more are as follows:




Year
      EndingDecember
      31,
            
            Amount2010
            
            $
            764,7042011
            
            
            705,5932012
            
            
            713,4932013
            
            
            716,0422014
            
            
            708,581Thereafter
            
            
            2,596,973$
            6,205,386







The total rental expense for the years
ended December 31, 2009 and 2008 for all facilities leased under operating
leases was approximately $759,000 and $627,000, respectively.







76







SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements






Note
8 - Deposits




A summary of deposit accounts with the
corresponding interest expense and weighted average rate are presented
below:




As
      of December 31, 2009
              
              
              As
      of December 31,  2008Deposit Balance
              
              
              Wtd
      Avg Rate
              
              
              Deposit
      Balance
              
              
              Wtd Avg RateChecking
      (non-interest)
              
              $
              21,226,575
              
              
              
              0.00
              %
              
              $
              13,176,999
              
              
              
              0.00
              %NOW
      (interest)
              
              
              28,197,116
              
              
              
              0.24
              %
              
              
              20,636,576
              
              
              
              0.61
              %Savings
              
              
              20,631,757
              
              
              
              0.30
              %
              
              
              12,521,879
              
              
              
              0.75
              %Money
      Market
              
              
              81,619,985
              
              
              
              0.90
              %
              
              
              51,744,024
              
              
              
              2.92
              %CDs
              
              
              135,888,344
              
              
              
              2.77
              %
              
              
              124,680,739
              
              
              
              4.11
              %Total
              
              $
              287,563,777
              
              
              
              1.60
              %
              
              $
              222,760,217
              
              
              
              3.04
              %







Scheduled
maturities of time deposits at December 31, 2009 are as follows:




Year
      EndingDecember
      31,
            
            Amount2010
            
            $
            88,625,2922011
            
            
            38,277,2302012
            
            
            3,553,6212013
            
            
            3,520,645Thereafter
            
            
            1,911,556$
            135,888,344







Savings
accounts, checking accounts, money market accounts, and individual retirement
savings accounts have no contractual maturity. Certificate accounts have
maturities of five years or less.




The aggregate amount of time deposits
in denominations of $100,000 or more at December 31, 2009 and 2008 was
approximately $67.1 million and $107.9 million, respectively. During 2010,
deposits in excess of $250,000 are not federally insured, except for
non-interest demand deposits, which are fully insured until June 30,
2010.  After 2013, deposits in excess of $100,000 will not be
federally insured, unless the higher levels of insurance in effect through 2013
are extended.




Deposits from related parties held by
the Company at December 31, 2009 and December 31, 8, amounted to $1,153,000 and
$965,000, respectively.






Note
9 – Borrowings




The Company utilizes a loan agreement
with the FHLB of Seattle. The terms of the agreement call for a blanket pledge
of a portion of the Company’s mortgage and commercial real estate portfolio
based on the outstanding balance. At December 31, 2009, the amount available to
borrow under this agreement is approximately 35% of total assets, or up to
$118.3 million subject to the availability of eligible collateral. The Company
had outstanding borrowings under this arrangement of $20.0 million and $42.2
million at December 31, 2009 and 2008, respectively.







77








SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements




Contractual
principal repayments are as follows:





Year
      Ending
              December
      31,
            
            Amount
            
            
            Weighted
      Average Rate(Dollars
      in thousands)2010
            
            $
            10,000
            
            
            
            4.33
            %2011
            
            
            10,000
            
            
            
            2.20
            %$
            20,000
            
            
            
            3.27
            %








2009
            
            
            2008
            
            
            2007(Dollars in thousands)Maximum balanceFHLB
      advances
            
            $
            41,950
            
            
            $
            56,119
            
            
            $
            34,519Average balancesFHLB
      advances
            
            $
            28,364
            
            
            $
            38,474
            
            
            $
            26,511Weighted average interest
    rateFHLB
      advances
            
            
            3.29
            %
            
            
            3.31
            %
            
            
            5.08
            %





The Company participates in the Federal
Reserve Bank’s Borrower-in-Custody program, which gives the Company access to
the discount window.  The terms of the program call for a pledge of
specific assets.  The Company had unused borrowing capacity of $17.0
million and $0 and no outstanding borrowings under this program at December 31,
2009 and 2008, respectively.





The Company has access to an unsecured
line of credit from the Pacific Coast Banker’s Bank.  This line of
credit is equal to $2.0 million as of December 31, 2009.  The line has
a one-year term and is renewable.  There was no balance on this line
of credit as of December 31, 2009 and 2008, respectively.




Note
10 – Earnings (loss) Per Share





Earnings
(loss) per share are summarized in the following table:





Years
      Ended December 31,2009
            
            
            2008Net
      income (loss)
            
            $
            (613,803
            )
            
            $
            261,575Weighted
      average number of shares outstanding, basic
            
            
            2,874,492
            
            
            
            2,903,911Effect
      of dilutive stock options
            
            
            -
            
            
            
            -Weighted
      average number of shares outstanding, diluted
            
            
            2,874,492
            
            
            
            2,903,911Earnings
      (loss) per share, basic
            
            $
            (0.21
            )
            
            $
            0.09Earnings
      (loss) per share, diluted
            
            $
            (0.21
            )
            
            $
            0.09





For the
year ended December 31, 2009, there were no non-dilutive securities included in
the calculation for earnings per share.





78






SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements






Note
11 – Employee Benefits




The
Company has a 401(k) pension plan that allows employees to defer a portion of
their salary into the 401(k) plan. The Company matches a portion of employees’
salary deferrals. Pension costs are accrued and funded on a current basis. The
Company contributed $86,000 and $117,000 to the plan for the years ended
December 31, 2009 and 2008, respectively.




The Company also offers a deferred
compensation plan for designated senior managers, which provides benefits
payable at age 65. Under certain circumstances, benefits are payable to
designated beneficiaries.  Contributions to the plan are
discretionary, and monies set aside to fund the plan are currently held in
certificate of deposit accounts at the Company and at December 31, 2009 and 2008
approximated $146,000 and $161,000, respectively. The Company contributed $0 and
$13,000 to the plan for the years ended December 31, 2009 and 2008,
respectively.




Effective in 2007, the board of
directors adopted a supplemental executive retirement plan (SERP) to provide
certain members of senior management with additional retirement income. These
payments are subject to a non-compete clause. The SERP is an unfunded,
non-contributory defined benefit plan evidenced by an Executive Long Term
Compensation Agreement between the recipients and the Company. The SERP is
subject to a vesting schedule and payments do not begin until after retirement.
The SERP provides for earlier payments in the event of death or disability. In
the event of an involuntary termination without cause or a change in control of
the Company, the recipients are entitled immediately to the accrued liability
under the SERP (with any applicable cutback for payments after a change in
control as required by Section 280(G) of the Internal Revenue Code). As of
December 31, 2009 and 2009, the accrued liability for the SERP was $397,000 and
$264,000, respectively, and are included in other liabilities on the
consolidated balance sheet. The expense was $134,000 and $148,000 for the year
ended December 31, 2009 and 2008, respectively.




Stock Options and Restricted
Stock




In 2008, the board of directors adopted
and shareholders approved an Equity Incentive Plan (the “Plan”).  The
Plan was approved by shareholders at the special meeting of shareholders held on
November 19, 2008.  The plan permits the grant of restricted stock and
stock options. Under the Plan 144,455 shares of common stock were approved for
stock options and stock appreciation right and 57,782 shares of common stock
were approved for restricted stock and restricted stock units.





On January 27, 2009, the Compensation
Committee of the Board of Directors of the Company awarded shares of restricted
stock and stock options to directors, executive officers and employees of the
Company, and its wholly owned subsidiary, Sound Community Bank, pursuant to the
Plan. The Company granted 25,998 non-qualified stock options and 82,400
incentive stock options to certain directors and employees.  The
Company also granted 52,032 shares of restricted stock to certain directors and
employees. During the year ended December 31, 2009, share based compensation
expense totaled $120,000.





All of the awards vest in 20 percent
annual increments over the next five years. The options are exercisable for a
period of 10 years from the date of grant, subject to vesting. Half of the stock
options granted to each of the individuals indicated above were at an exercise
price of $7.35, which was the fair market value of the Company’s common stock on
the grant date. The remaining half of the stock options granted to each of the
individuals indicated above were at an exercise price of $8.50, which was $1.15
above the fair market value of the Company’s common stock on the grant date. The
vesting date for options and restricted stock is accelerated in the event of the
grantee’s death, disability or a change in control of the Company.







79








SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements




Stock
Options





The fair value of each option award is
estimated on the date of grant using a Black-Scholes model that uses the
assumptions noted in the table below.  The dividend yield is based on
the current quarterly dividend in effect at the time of the
grant.





The Company became a publicly held
company in January 2008, so the amount of historical stock price information
available is limited.  As a result, the Company elected to use a
weighted-average of its peers’ historical stock prices, as well as the Company’s
own historical stock prices to estimate volatility.  The Company bases
the risk-free interest rate on the U.S. Treasury Constant Maturity Indices in
effect on the date of the grant.  The Company elected to use the Staff
Accounting Bulletin No. 110, “Share-Based Payments” permitted by the Securities
and Exchange Commission to calculate the expected term.  This
simplified method uses the vesting term of an option along with the contractual
term, setting the expected life at a midpoint in between.





The fair
value of options granted during 2009 was determined using the following
weighted-average assumptions as of the grant date.





Annual
      dividend yield
            
            
            2.20
            %Expected
      volatility
            
            
            30.00
            %Risk-free
      interest rate
            
            
            2.09
            %Expected
      term
            
            7.5
      yearsWeighted-average
      grant date fair value per option granted
            
            $
            2.56





The
following is a summary of the Company’s stock option plan awards during the
period ended December 31, 2009:





Shares
            
            Weighted-Average
      Exercise Price
            
            Weighted-Average
      Remaining Contractual Term In Years
            
            Aggregate
      Intrinsic ValueOutstanding
      at the beginning of the year
            
            -
            
            $                 -Granted
            
            108,398
            
            7.93Exercised
            
            -
            
            -Forfeited
      or expired
            
            -
            
            7.93Outstanding
      at December 31, 2009
            
            108,398
            
            $              7.93
            
            9.34
            
            $             -Expected
      to vest, assuming a 0% forfeiture rate over the vesting
    term
            
            108,398
            
            $              7.93
            
            9.34
            
            $             -








80





There were no exercisable stock options
as of December 31, 2009. The aggregate intrinsic value of the stock options as
of December 31, 2009 was $0.





As of
December 31, 2009, there was $227,000 of total unrecognized compensation cost
related to nonvested stock options granted under the Plan.  The cost
is expected to be recognized over the remaining weighted-average vesting period
of 4.09 years.  No options were exercisable at December 30,
2009.








81








SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements




Restricted
Stock Awards





The fair
value of the restricted stock awards is equal to the fair value of the Company’s
stock at the date of grant. Compensation expense is recognized over the
vesting period that the awards are based. Shares awarded as restricted
stock vest ratably over a five-year period beginning at the grant date with 20%
vesting on the anniversary date of each grant date. In November 2008, the Board
of Directors authorized management to repurchase up to 57,782 shares of the
Company’s outstanding stock over a twelve-month period in order to fund the
restricted stock awards made under the Plan. As of December 31, 2009, 45,800
shares have been repurchased under the Plan.





The
following is a summary of the Company’s nonvested restricted stock awards for
the year ended December 31, 2009:




Nonvested Shares
            
            Shares
            
            
            Weighted-
              Average
      Grant-
              Date
      Fair Value
            
            
            Aggregate
              Intrinsic
      ValueNonvested
      at January 1, 2009
            
            
            -
            
            
            
            -Granted
            
            
            52,032
            
            
            $
            7.35Vested
            
            
            -
            
            
            
            -Forfeited
            
            
            -
            
            
            
            -Nonvested
      at December 31, 2009
            
            
            52,032
            
            
            $
            7.35
            
            
            $
            4.40-Expected
      to vest assuming a 0%
              forfeiture
      rate over the vesting term
            
            
            52,032
            
            
            $
            7.35
            
            
            $
            4.40





The
aggregate intrinsic value of the restricted stock options as of December 31,
2009 was $229,000.





As of December 31, 2009, there was
$313,000 of unrecognized compensation cost related to non-vested restricted
stock granted under Plan.  The cost is expected to be recognized over the
weighted-average vesting period of 4.09 years.





Employee
Stock Ownership Plan





In January 2008, the ESOP borrowed
$1,155,600 from the Company to purchase common stock of the Company. The loan is
being repaid principally from the Company’s contributions to the ESOP over a
period of ten years. The interest rate on the loan is fixed at 4.0% per
annum.  As of December 31, 2009, the remaining balance of the ESOP
loan was $962,000.  Neither the loan nor the related interest is
reflected on the consolidated financial statements.





At
December 31, 2009, the ESOP was committed to release 11,556 shares of the
Company’s common stock to participants and held 92,448 unallocated shares
remaining to be released in future years.  The fair value of the
92,448 restricted shares held by the ESOP trust was $407,000 at December 31,
2009.  ESOP compensation expense included in salaries and benefits was
$72,000 for the year ended December 31, 2009.








82





SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements






Note
12 – Income Taxes




The
provision (benefit) for income taxes are as follows:




2009
            
            
            2008Current
            
            $
            256,373
            
            
            $
            331,095Deferred
            
            
            (721,000
            )
            
            
            (286,000
            )Total
      tax expense
            
            $
            (464,627
            )
            
            $
            45,095




A
reconciliation of the provision (benefit) for income taxes with amounts
determined by applying the statutory U.S. federal income tax rate to income
before income taxes is as follows:







Provision
      at statutory rate
            
            $
            (366,666
            )
            
            $
            104,268Tax-exempt
      income
            
            
            (111,265
            )
            
            
            (71,156
            )Other
            
            
            13,304
            
            
            
            11,983$
            (464,627
            )
            
            $
            45,095Federal
      Statutory Rate
            
            
            34.0
            %
            
            
            34.0
            %Tax
      exempt income
            
            
            (10.3
            )%
            
            
            (23.2
            )%Other
            
            
            (1.2
            )%
            
            
            3.9
            %Effective
      income tax rate
            
            
            22.5
            %
            
            
            14.7
            %







Significant
components of the Company’s deferred tax assets are as follows:




Deferred
      tax assetsDeferred
      compensation & supplemental retirement
            
            $
            137,000
            
            
            $
            144,000Other,
      net
            
            
            6,000
            
            
            
            19,000Unrealized
      loss on securities
            
            
            525,000
            
            
            
            408,000Charitable
      contributions
            
            
            50,000
            
            
            
            58,000Non-accrual
      interest
            
            
            55,000
            
            
            
            19,000Equity
      based compensation
            
            
            28,000
            
            
            
            -Allowance
      for loan losses
            
            
            810,000
            
            
            
            115,000Total
      deferred tax assets
            
            
            1,611,000
            
            
            
            763,000Deferred
      tax liabilitiesPrepaid
      expenses
            
            
            (41,000
            )
            
            
            36,000Deferred
      loan fee income
            
            
            (34,000
            )
            
            
            54,000FHLB
      stock dividends
            
            
            (142,000
            )
            
            
            142,000Depreciation
            
            
            (62,000
            )
            
            
            70,000Intangible
      assets
            
            
            (64,000
            )
            
            
            -Deferred
      loan costs
            
            
            (168,000
            )
            
            
            199,000Total
      deferred tax liabilities
            
            
            (511,000
            )
            
            
            501,000Net
      deferred tax asset (liability)
            
            $
            1,100,000
            
            
            $
            262,000





The Company adopted the provisions of
FASB ASC Topic 740 on January 1, 2007 related to uncertain tax
positions.  As of December 31, 2009, we had no unrecognized tax
benefits.  The Company recognizes interest accrued and penalties
related to unrecognized tax benefits in “Provision (benefit) for income taxes”
in the consolidated statements of operations.  During the years ended
December 31, 2009 and 2008, the Company recognized no interest and
penalties.













83





SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements




The Company or its subsidiary files an
income tax return in the U.S. federal jurisdiction, and various states. 
With few exceptions, the Company is no longer subject to U.S. federal or
state/local income tax examinations by tax authorities for years before
2006.






Note
13 – Minimum Regulatory Capital Requirements




The Bank is subject to various
regulatory capital requirements administered by the federal banking agencies.
Failure to meet minimum capital requirements can initiate certain mandatory and
possibly additional discretionary actions by regulators that, if undertaken,
could have a direct material effect on the Company’s financial statements. The
regulations require the Company to meet specific capital adequacy guidelines
that involve quantitative measures of the Company’s assets, liabilities, and
certain off-balance-sheet items as calculated under regulatory accounting
practices. The Company’s capital classification is also subject to qualitative
judgments by the regulators about components, risk weightings, and other
factors.




Quantitative measures established by
regulation to ensure capital adequacy require the Company to maintain minimum
amounts and ratios (set forth in the following table) of total and Tier 1
capital (as defined) to risk-weighted assets (as defined) and Tier 1 capital to
average assets (as defined). Management believes that, as of December 31, 2009
and 2008, the Company meets all capital adequacy requirements to which it is
subject.




As of December 31, 2009, the most
recent notification from the Federal Deposit Insurance Corporation categorized
the Company as well capitalized under the regulatory framework for prompt
corrective action. To be categorized as well capitalized, an institution must
maintain minimum total Tier 1 risk-based and Tier 1 leverage ratios as set forth
in the following table. There are no conditions or events since the notification
that management believes have changed the Company’s category.







84







SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements






The
Company’s actual capital amounts (in thousands) and ratios as of December 31,
2009 and 2008 are presented in the following table:


Actual
              
              For
      Capital
                Adequacy
      Purposes
              
              To
      Be Well Capitalized
                Under
      Prompt Corrective
                Action
      ProvisionsAmount
              
              Ratio
              
              Amount
              
              Ratio
              
              Amount
              
              RatioAs
      of December 31, 2009Total
      Capital to Risk-Weighted Assets
              $   27,996
              
              11.7%
              
              $   19,189
              >
              8.0%
              
              $   23,986
              >
              10.0%Tier
      I Capital to Risk-Weighted Assets
              $   24,998
              
              10.4%
              
              $     9,594
              >
              4.0%
              
              $   14,391
              >
              6.0%Tier
      I Capital to Average Assets
              $   24,998
              
              7.4%
              
              $   13,563
              >
              4.0%
              
              $   16,954
              >
              5.0%As
      of December 31, 2008Total
      Capital to Risk-Weighted Assets
              $   25,686
              
              12.40%
              
              $     16,569
              >
              8.0%
              
              $     20,712
              >
              10.0%Tier
      I Capital to Risk-Weighted Assets
              $   24,393
              
              11.77%
              
              $       8,285
              >
              4.0%
              
              $     12,427
              >
              6.0%Tier
      I Capital to Average Assets
              $   24,393
              
              8.31%
              
              $     11,740
              >
              4.0%
              
              $     14,675
              >
              5.0%


________________________


(1)
            Based
      on total adjusted assets of $339.1
million.


(2)
            Based
      on risk-weighted assets of $239.9
million.


(3)
            The
      Tier 1 risk-based capital requirement for a well-capitalized institution
      is 6% of risk-weighted assets.  See “How We Are Regulated -
      Regulatory Capital Requirements.”




Regulatory capital levels reported
above differ from the Company’s total capital, computed in accordance with
accounting principles generally accepted in the United States (GAAP) as follows
(in thousands):




2009
            
            
            2008Equity
            
            $
            24,058
            
            
            $
            23,600Accumulated
      other comprehensive(income)
      loss
            
            
            940
            
            
            
            793Total
      Tier 1 capital
            
            $
            24,998
            
            
            $
            24,393Allowance
      for loan and lease losses
            
            $
            2,998
            
            
            $
            1,306Unrealized
      gain on AFS securities
            
            
            -
            
            
            
            -Total
      capital
            
            $
            27,996
            
            
            $
            25,686




The
Company declared a dividend of $0.02 per common share on February 9, 2010. The
dividend will be paid on February 25, 2010 to shareholders of record on February
19, 2010.




Note
14 – Fair Value Measurements





The
following table presents the balances of assets measured at fair value on a
recurring basis at December 31, 2009:




Fair
      Value at December 31, 2009Description
            
            Total
            
            
            Level
      1
            
            
            Level
      2
            
            
            Level
      3Mortgage
      Servicing Rights, at fair value
            
            $
            2,017,489
            
            
            $
            -
            
            
            $
            -
            
            
            $
            2,017,489AFS
      Securities
            
            
            9,899,092
            
            
            
            -
            
            
            
            9,899,092
            
            
            
            -$
            11,916,581
            
            
            $
            -
            
            
            $
            9,899,092
            
            
            $
            2,017,489








85





SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements




The following table presents the
balances of assets measured at fair value on a recurring basis at December 31,
2008:




Fair
      Value at December 31, 2008Description
            
            Total
            
            
            Level
      1
            
            
            Level
      2
            
            
            Level
      3AFS
      Securities
            
            $
            8,929,798
            
            
            $
            -
            
            
            $
            5,676,787
            
            
            $
            3,253,011





A
description of the valuation methodologies used for recurring fair value
measurements is as follows:





AFS Securities – AFS
securities are recorded at fair value based on quoted market prices, if
available. If quoted market prices are not available, management utilizes
third-party pricing services or broker quotations from dealers in the specific
instruments or based on discounted cash flow models. Level 1 securities include
those traded on an active exchange, as well as U.S. government and its agencies
securities. Level 2 securities include agency and non-agency mortgage-backed
securities.





Mortgage Servicing Rights -
The fair value of purchased mortgage servicing rights is estimated using a
discounted cash flow model based on market information from a third party. These
assets are classified as Level 3.  At December 31, 2009, certain
mortgage servicing rights are carried at fair value.





The following table presents activity
for recurring fair value measurements for assets that were measured using Level
3 fair value inputs during 2009:





Level
      3 at December 31, 2008
            
            
            Change
      included in earnings
            
            
            Purchases,
      issuances and settlements
            
            
            Net
      Change in Unrealized Losses
            
            
            Net
      Transfers in (out) of
              Level
      3
            
            
            Level
      3 at
              December
      31, 2009Non-Agency
      Mortgage Backed Securities
            
            $
            3,253,011
            
            
            $
            34,175
            
            
            $
            (322,275
            )
            
            $
            (499,451
            )
            
            $
            (2,465,460
            )
            
            $
            -Mortgage
      Servicing Rights, fair value
            
            $
            -
            
            
            $
            124,618
            
            
            $
            1,892,871
            
            
            $
            -
            
            
            $
            -
            
            
            $
            2,017,489





For the
twelve months ended December 31, 2009 there were no transfers from Level 2 to
Level 3. There were $2.5 million in transfers from Level 3 to Level 2 during the
twelve months ended December 31, 2009.  The transfers occurred as a
result of the Company’s ability to obtain quoted prices for similar assets or
liabilities in markets that are not active for all of the securities previously
reported as Level 3.





The
following tables present the balance of assets measured at fair value on a
nonrecurring basis at December 31, 2009 and 2008, and the total losses resulting
from these fair value adjustments for the years ended December 31, 2009 and
2008:




Fair
      Value at December 31, 2009
            
            
            Twelve
      Months
              Ended
      December 31, 2009Description
            
            Total
            
            
            Level
      1
            
            
            Level
      2
            
            
            Level
      3
            
            
            Total
      LossesLoans
      Held for Sale
            
            $
            2,857,700
            
            
            
            -
            
            
            $
            2,857,700
            
            
            $
            -
            
            
            $
            -Mortgage
      Servicing Rights, at cost
            
            
            1,309,809
            
            
            
            -
            
            
            
            -
            
            
            
            1,309,809
            
            
            
            38,677OREO
      and Repossessed Assets
            
            
            1,383,638
            
            
            
            -
            
            
            
            -
            
            
            
            1,383,638
            
            
            
            627,089Impaired
      Loans
            
            
            11,719,926
            
            
            
            -
            
            
            
            -
            
            
            
            11,719,926
            
            
            
            1,424,270Total
            
            $
            17,271,073
            
            
            
            -
            
            
            $
            2,857,700
            
            
            $
            14,413,373
            
            
            $
            2,090,036








86







SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements




Fair
      Value at December 31, 2008
            
            
            Twelve
      Months
              Ended
              December
      31,
              2008Description
            
            Total
            
            
            Level
      1
            
            
            Level
      2
            
            
            Level
      3
            
            
            Total
      LossesLoans
      Held for Sale
            
            $
            955,595
            
            
            
            -
            
            
            $
            -
            
            
            $
            955,595
            
            
            $
            -Mortgage
      Servicing Rights, at cost
            
            
            863,146
            
            
            
            -
            
            
            
            863,146
            
            
            
            -
            
            
            
            57,126OREO
      and Repossessed Assets
            
            
            1,724,567
            
            
            
            -
            
            
            
            -
            
            
            
            1,724,567
            
            
            
            33,500Impaired
      Loans
            
            
            5,584,551
            
            
            
            -
            
            
            
            -
            
            
            
            5,584,551
            
            
            
            581,177Total
            
            $
            9,127,859
            
            
            
            -
            
            
            $
            863,146
            
            
            $
            8,264,713
            
            
            $
            671,803





Loans Held for Sale -
Residential mortgage loans held for sale are recorded at the lower of cost or
fair value. The fair value of fixed-rate residential loans is based on whole
loan forward prices obtained from government sponsored enterprises. These loans
are classified as Level 2 and are measured on a nonrecurring
basis.  At December 31, 2009, loans held for sale were carried at
cost.





Mortgage Servicing Rights -
Originated mortgage servicing rights are recorded at the lower of cost or fair
value by tranche. The fair value of purchased mortgage servicing rights is
estimated using a discounted cash flow model based on market information from a
third party. These assets are classified as Level 3.





OREO and Repossessed Assets-
OREO and repossessed assets consist principally of properties acquired through
foreclosure and are carried at the lower of cost or estimated market value less
selling costs.  Any write-downs based on the asset’s fair value at the
date of acquisition are charged to the allowance for loan losses. After
foreclosure, management periodically performs valuations such that the real
estate is carried at the lower of its new cost basis or fair value, net of
estimated costs to sell.  These assets are classified as level
3.





Impaired Loans – Impaired
loans are calculated using the collateral value method. Inputs include appraised
value, estimates of certain completion, closing and selling
costs.  These assets are classified as level 3.





The
Company has written-down impaired loans by $1.4 million as of December 31,
2009.  At the applicable foreclosure or repossession date, OREO and
other repossessed assets are recorded at the fair value of the collateral less
applicable selling costs.  The carrying value of OREO and other
repossessed assets are regularly evaluated and, if necessary, an allowance is
established to reduce the carrying value to net realizable
value.  Loss on the sale of OREO and repossessed assets totaled
$627,000 as of December 31, 2009, reflecting further decreases in collateral
values compared to the foreclosure or repossession date.





There
were no liabilities carried at fair value, measured on a recurring or
nonrecurring basis, at December 31, 2009.





87







SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements





The carrying amounts and estimated fair
values of the Company’s financial instruments is summarized as
follows:




December
      31, 2009
            
            
            December
      31, 2008Carrying
            
            
            Fair
            
            
            Carrying
            
            
            FairAmount
            
            
            Value
            
            
            Amount
            
            
            ValueFinancial
      assets:Cash
      and cash equivalents
            
            $
            15,678,766
            
            
            $
            15,678,766
            
            
            $
            5,607,800
            
            
            $
            5,607,800AFS
      Securities
            
            
            9,899,092
            
            
            
            9,899,092
            
            
            
            8,929,798
            
            
            
            8,929,798FHLB
      stock
            
            
            2,444,000
            
            
            
            2,444,000
            
            
            
            2,444,000
            
            
            
            2,444,000Loans
      held for sale
            
            
            2,857,700
            
            
            
            2,857,700
            
            
            
            955,595
            
            
            
            955,595Loans,
      net
            
            
            286,356,566
            
            
            
            286,430,669
            
            
            
            262,406,847
            
            
            
            262,211,517Accrued
      interest receivable
            
            
            1,305,590
            
            
            
            1,305,590
            
            
            
            1,219,645
            
            
            
            1,219,645Bank-owned
      life insurance
            
            
            6,462,892
            
            
            
            6,462,892
            
            
            
            6,195,055
            
            
            
            6,195,055Mortgage
      servicing rights, fair value
            
            
            2,017,489
            
            
            
            2,017,489
            
            
            
            -
            
            
            
            -Mortgage
      servicing rights, at cost
            
            
            1,309,809
            
            
            
            1,360,417
            
            
            
            863,146
            
            
            
            863,146Financial
      liabilities:Demand
      deposits
            
            $
            151,675,433
            
            
            $
            151,675,434
            
            
            $
            98,079,478
            
            
            $
            98,079,478Time
      deposits
            
            
            135,888,344
            
            
            
            137,833,241
            
            
            
            124,680,739
            
            
            
            123,280,368Borrowings
            
            
            20,000,000
            
            
            
            19,735,005
            
            
            
            42,219,355
            
            
            
            41,909,153Accrued
      interest payable
            
            
            166,043
            
            
            
            166,043
            
            
            
            259,757
            
            
            
            259,757Advance
      payments from borrowersfor
      taxes and insurance
            
            
            339,566
            
            
            
            339,566
            
            
            
            330,319
            
            
            
            330,319





Cash and cash equivalents, accrued
interest receivable and payable, and advance payments from borrowers for taxes
and insurance - The estimated fair value is equal to the carrying
amount.





AFS Securities – AFS
securities are recorded at fair value based on quoted market prices, if
available. If quoted market prices are not available, management utilizes
third-party pricing services or broker quotations from dealers in the specific
instruments or based on discounted cash flow models. Level 2 securities include
agency and non-agency mortgage-backed securities.





FHLB stock - The estimated
fair value is equal to the par value of the stock.





Loans - The estimated fair
value for all fixed rate loans is determined by discounting the estimated cash
flows using the current rate at which similar loans would be made to borrowers
with similar credit ratings and maturities. The estimated fair value for
variable rate loans is the carrying amount. The fair value for all loans also
takes into account projected credit losses as a part of the
estimate.




Loans Held for Sale -
Residential mortgage loans held for sale are recorded at the lower of cost or
fair value. The fair value of fixed-rate residential loans is based on whole
loan forward prices obtained from government sponsored enterprises. These loans
are classified as Level 2 and are measured on a nonrecurring basis.




Bank-owned Life Insurance -The estimated fair value is equal to the outstanding book value of
policies.







88







SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements





Mortgage Servicing
Rights – Originated mortgage servicing rights are recorded at the lower
of cost or fair value by tranche. The fair value of purchased mortgage servicing
rights is estimated using a discounted cash flow model based on market
information from a third party. These assets are classified as Level
3.  At December 31, 2009, acquired mortgage servicing rights are
carried at fair value and originated mortgage servicing rights are carried at
amortized cost.




Deposits -
The estimated fair value of deposit accounts (savings, demand deposit, and money
market accounts) is the carrying amount. The fair value of fixed-maturity time
certificates of deposit are estimated by discounting the estimated cash flows
using the current rate at which similar certificates would be
issued.




Borrowings -
The fair value of FHLB advances are estimated using discounted cash flow
analyses, based on the Bank’s current incremental borrowing rates for similar
types of borrowing arrangements.




Off-balance-sheet
financial instruments - The fair value for the Bank’s off-balance-sheet
loan commitments are estimated based on fees charged to others to enter into
similar agreements taking into account the remaining terms of the agreements and
credit standing of the Bank’s customers. The estimated fair value of these
commitments is not significant.





We assume
interest rate risk (the risk that general interest rate levels will change) as a
result of our normal operations. As a result, the fair values of our financial
instruments will change when interest rate levels change, which may be favorable
or unfavorable to us. Management attempts to match maturities of assets and
liabilities to the extent necessary or possible to minimize interest rate risk.
However, borrowers with fixed-rate obligations are less likely to prepay in a
rising rate environment and more likely to prepay in a falling rate environment.
Conversely, depositors who are receiving fixed rates are more likely to withdraw
funds before maturity in a rising rate environment and less likely to do so in a
falling rate environment. Management monitors rates and maturities of assets and
liabilities and attempts to minimize interest rate risk by establishing early
withdrawal penalties for certificates of deposit, creating interest rate floors
for certain variable rate loans, adjusting terms of new loans and deposits, by
borrowing at fixed rates for fixed terms and investing in securities with terms
that mitigate our overall interest rate risk.




Note
15 – Concentrations of Credit Risk




Most of the Company’s business activity
is with customers located in the state of Washington. A substantial portion of
the loan portfolio is represented by 1-4 family mortgage loans throughout
western Washington. The ability of the Company’s debtors to honor their
contracts is dependent upon the real estate and general economic conditions in
the area. Loans to one borrower are limited by federal banking regulations to
15% of the Company’s equity, excluding accumulated other comprehensive income
(loss).




Note
16 – Commitments and Contingent Liabilities




The Company is a party to financial
instruments with off-balance-sheet risk in the normal course of business to meet
the financing needs of its customers. These financial instruments generally
represent a commitment to extend credit in the form of loans. The instruments
involve, to varying degrees, elements of credit and interest rate risk in excess
of the amount recognized in the consolidated statement of financial
condition.




The Company’s exposure to credit loss,
in the event of nonperformance by the other party to the financial instrument
for commitments to extend credit, is represented by the contractual notional
amount of those instruments.







89





SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements







The Company uses the same credit
policies in making commitments as it does for on-balance-sheet
instruments.




Commitments to extend credit are
agreements to lend to a customer as long as there is no violation of any
condition established by the contract. Commitments generally have fixed
expiration dates or other termination clauses and may require payment of a fee.
Because many of the commitments are expected to expire without being drawn upon,
the total commitment amounts do not necessarily represent future cash
requirements. The Company evaluates each customer’s creditworthiness on a
case-by-case basis. The amount of collateral obtained, if it is deemed necessary
by the Company, is based on management’s credit evaluation of the
customer.




Financial instruments whose contract
amount represents credit risk were as follows:




2009
            
            
            2008Unused
      home equity lines of credit
            
            $
            21,130,713
            
            
            $
            22,959,662Unused
      personal line of credit
            
            
            2,676,506
            
            
            
            2,856,705Unused
      business line of credit
            
            
            4,701,602
            
            
            
            6,312,060Undisbursed
      portion of loans closed
            
            
            4,455,096
            
            
            
            1,811,247Irrevocable
      letters of credit
            
            
            264,900
            
            
            
            2,283,450Residential
      mortgage commitments
            
            
            1,932,500
            
            
            
            5,608,700$
            35,161,317
            
            
            $
            41,831,824





At December 31, 2009, fixed rate loan
commitments totaled $1.9 million and had a weighted average interest rate of
4.67%. At December 31, 2008, fixed rate loan commitments totaled $3.2 million
and had a weighted average interest rate of 4.80%.




Commitments for credit may expire
without being drawn upon. Therefore, the total commitment amount does not
necessarily represent future cash requirements of the Company. These commitments
are not reflected in the financial statements.




In the ordinary course of business, the
Company sells loans without recourse that may have to be subsequently
repurchased due to defects that occurred during the origination of the loan. The
defects are categorized as documentation errors, underwriting errors, early
payment defaults, and fraud.  When a loan sold to an investor without
recourse fails to perform, the investor will typically review the loan file to
determine whether defects in the origination process occurred. If a defect is
identified, the Company may be required to either repurchase the loan or
indemnify the investor for losses sustained. If there are not defects, the
Company has no commitment to repurchase the loan. As of December 31, 2009 and
2008, the maximum amount of these guarantees totaled $181.4 million and $141.5
million, respectively. These amounts represent the unpaid principal balances of
the Company’s loans serviced for others’ portfolios. The Company has recorded no
reserve to cover loss exposure related to these guarantees.  No loans
were repurchased for the years ended December 31, 2009 and 2008.




The Company pays certain medical,
dental, prescription, and vision claims for its employees, on a self-insured
basis. The Company has purchased stop-loss insurance to cover claims that exceed
stated limits and has recorded estimated reserves for the ultimate costs for
both reported claims and claims incurred but not reported, which are not
considered significant at December 31, 2009 and 2008.




At various times, the Company may be
the defendant in various legal proceedings arising in connection with its
business. It is the opinion of management that the financial position and the
results of operations of the Company will not be materially adversely affected
by the outcome of these legal proceedings and that adequate provision has been
made in the accompanying consolidated financial statements.







90






SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements







Note
17 - Legal Proceedings




In
November 2007, Visa Inc. (“Visa”) announced that it had reached a settlement
with American Express and Discover Card related to antitrust lawsuits. The
Company and other Visa member banks were obligated to fund the settlement and
share in losses resulting from this litigation.  The Company is not a
party to the Visa litigation and its liability arises solely from the Company’s
membership interest in Visa, Inc.





In the first quarter of 2008, Visa
completed an initial public offering and the Company received $154,000 as part
of a subsequent mandatory partial redemption of our Visa Class B
shares.  Using the proceeds from this offering, Visa established a
$3.0 billion escrow account to cover settlements, the resolution of pending
litigation and related claims (“covered litigation”).





As of December 31, 2009, the Company
owned 5,699 shares of Class B common stock.  These shares are
restricted and may not be transferred until the later of (i) three years
from the date of the initial public offering or (ii) the period of time
necessary to resolve the covered litigation.  A conversion ratio of
0.71429 was initially established for the conversion rate of Class B shares into
Class A shares.  If the funds in the escrow account are
insufficient to settle all the covered litigation, Visa may sell additional
Class A shares, use the proceeds to settle litigation, and further reduce
the conversion ratio.  If funds remain in the escrow account after all
litigation is settled, the Class B conversion ratio will be increased to reflect
that surplus.  In December 2008, Visa deposited additional funds into
the escrow account to satisfy a settlement with Discover Card related to and
antitrust lawsuit.  In July 2009, Visa deposited additional funds into
the litigation escrow account to provide additional reserves to cover potential
losses related to the two remaining litigation cases.  This deposit
reduced the conversion ratio applicable to Class B shares outstanding from
0.71429 to 0.5824 per Class A share.





As of December 31, 2009, the value of
the Class A shares was $87.46 per share.  Using the new conversion
ratio, the value of unredeemed Class A equivalent shares owned by the Company
was $290,000, and has not been reflected in the accompanying financial
statements.





In the
normal course of business, the Company occasionally becomes involved in various
legal proceedings.  In the opinion of management, any liability from
such proceedings would not have a material adverse effect on the business or
financial condition of the Company.





Note
18 – Acquisition of 1st
Security Bank of Washington Branches





On August 29, 2009, the Company
completed its acquisition of two branches of 1st Security Bank of Washington
(“1st Security”), located at 2941 South 38th Street, Tacoma, Washington and 1405
E. Front Street, Port Angeles, Washington.  These branch acquisitions
were completed under two Purchase and Assumption Agreements between the Company
and 1st
Security.  In this branch acquisition, the Company purchased the
deposit-related loans and certain personal property and records at the former
1st
Security branches and the building and real estate at the Port Angeles
branch.  These assets were acquired in exchange for Sound’s assumption
of the deposits at the two branches and the lease at the Tacoma branch, as well
as the payment of a deposit premium of 2.25% on the Tacoma deposits and 2.5% on
the Port Angeles deposits (or an aggregate deposit premium of
$801,000).





The
Company moved the operations of its Lakewood Towne Center branch to its new
Tacoma branch on October 16, 2009, and the operations of the acquired Port
Angeles facility to the Company’s new branch location at 110 North Alder Street
in Port Angeles.





91










SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements





The
acquisition was accounted for under the purchase method of accounting in
accordance with FASB ASC Topic 805, Business Combinations.  The assets
acquired and liabilities assumed were recorded at fair value.  Fair
values are preliminary and are subject to refinements for up to one year after
the closing date of an acquisition as information relative to closing date fair
values becomes available.  As of December 31, 2009, the fair values
for acquired assets and liabilities remained open.  A “bargain
purchase gain” totaling approximately $227,000 resulted from the acquisition and
is included as a component of noninterest income on the consolidated statement
of operations.  The amount of gain is equal to the amount by which the
fair value of assets purchased exceeded the fair value of liabilities
assumed.  The estimated fair value of the assets purchased and
liabilities assumed are presented in the following table:




Fair
      value of assets acquired
            
            August
      29, 2009Cash
      and cash equivalents
            
            $
            31,729,000Loans,
      net
            
            
            241,000Premises
      and equipment, net
            
            
            750,000Core
      deposit intangibles
            
            
            1,160,000Other
      assets
            
            
            32,000Total
      fair value of assets acquired
            
            $
            33,912,000Fair
      value of liabilities assumedDeposits
            
            $
            33,553,000CD
      negative premium
            
            
            132,000Total
      fair value of liabilities assumed
            
            $
            33,685,000Gain
      on bargain purchase
            
            $
            227,000





The core
deposit intangible asset represents the value ascribed to the long-term deposit
relationships acquired.  This intangible asset is being amortized on a
straight-line basis over a weighted average estimated useful life of 9.5
years.  The core deposit intangible asset is not estimated to have a
significant residual value.  There is a negative CD premium of
$132,000, or -0.79% of book value.  The value is a result of the
current all-in cost of the CD portfolio being well above the cost of similar
funding.





The
following table represents unaudited pro forma results of operations for the
year ended December 31, 2009 and 2008, as if the acquisition of the 1st
Security branches had occurred at the beginning of the earliest period
presented.  The pro forma results have been prepared for comparative
purposes only by estimating net interest income, non-interest income and
non-interest expense for the nine month periods as if the acquisition had
occurred at the earliest period presented and are not necessarily indicative of
the results that would have been obtained had the acquisitions actually occurred
at the beginning of the earliest period presented.  Management of the
Bank anticipates that cost savings and operational synergies not currently
reflected will be realized when the operations of 1st
Security Bank of Washington are fully integrated in 2009.  Acquisition
related expenses of approximately $132,000 were expensed in the current
period.





92





SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to Consolidated Financial
Statements





Year
      Ended December 31,2009
            
            
            2008Net
      interest income
            
            $
            12,937,000
            
            
            $
            10,049,000Provision
      for loan losses
            
            
            4,275,000
            
            
            
            1,110,000Non-interest
      income
            
            
            3,489,000
            
            
            
            2,355,000Non-interest
      expense
            
            
            12,903,000
            
            
            
            10,724,000Income
      (loss)before income taxes (benefit)
            
            
            (752,000
            )
            
            
            570,000Provision
      (benefit) for income taxes
            
            
            (354,000
            )
            
            
            135,000Net
      Income
            
            $
            (398,000
            )
            
            $
            435,000







The pro
forma amounts in the above table have been adjusted to reflect the branch
acquisitions for the periods indicated.  Net interest income was
determined based on an estimate of interest income on agency mortgage backed
securities less interest expense based on the cost of funds on the deposits
acquired.




There was
no change to the provision for loan losses as a result of the branch
acquisitions.  Non-interest income included additional estimated
income related to service charges on deposit accounts. Non-interest expense
included additional estimated costs related to compensation, operations,
occupancy and data processing.




The
revenue and earnings since the acquisition date (August 29, 2009) included in
the consolidated financial statements as of and for the period ended December
31, 2009, are not considered significant.







93





Item
9.            Changes
In and Disagreements With Accountants on Accounting and
Financial  Disclosure.




None.







Item
9A(T).     Controls and Procedures.




(a)Evaluation of Disclosure
Controls and Procedures




An
evaluation of our disclosure controls and procedures (as defined in Rule
13a-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)) as of
December 31, 2009, was carried out under the supervision and with the
participation of the our Chief Executive Officer, Principal Financial Officer
and several other members of our senior management team within the 90-day period
preceding the filing of this annual report.  Our Chief Executive
Officer and Principal Financial Officer concluded that, as of December 31, 2009,
our disclosure controls and procedures were effective in ensuring that the
information required to be disclosed by us in the reports we file or submit
under the Exchange Act is (i) accumulated and communicated to our management
(including our Chief Executive Officer and Principal Financial Officer) in a
timely manner, and (ii) recorded, processed, summarized and reported within the
time periods specified in the SEC’s rules and forms.




We intend
to continually review and evaluate the design and effectiveness of the Company's
disclosure controls and procedures and to improve the Company's controls and
procedures over time and to correct any deficiencies that we may discover in the
future.  The goal is to ensure that senior management has timely
access to all material financial and non-financial information concerning the
Company's business.  While we believe the present design of the
disclosure controls and procedures is effective to achieve its goal, future
events affecting its business may cause the Company to modify its disclosure
controls and procedures.




The
Company does not expect that its disclosure controls and procedures will prevent
all error and all fraud.  A control procedure, no matter how well
conceived and operated, can provide only reasonable, not absolute, assurance
that the objectives of the control procedure are met.  Because of the
inherent limitations in all control procedures, no evaluation of controls can
provide absolute assurance that all control issues and instances of fraud, if
any, within the Company have been detected.  These inherent
limitations include the realities that judgments in decision-making can be
faulty, and that breakdowns can occur because of simple error or
mistake.  Additionally, controls can be circumvented by the individual
acts of some persons, by collusion of two or more people, or by management
override of the control.  The design of any control procedure also is
based in part upon certain assumptions about the likelihood of future events,
and there can be no assurance that any design will succeed in achieving its
stated goals under all potential future conditions; over time, controls may
become inadequate because of changes in conditions, or the degree of compliance
with the policies or procedures may deteriorate. Because of the inherent
limitations in a cost-effective control procedure, misstatements due to error or
fraud may occur and not be detected.





(b)Internal Control Over
Financial Reporting




There
were no changes in our internal control over financial reporting (as defined in
Rule 13a-15(f) under the Act) that occurred during the quarter ended December
31, 2009, that have materially affected, or are reasonably likely to materially
affect, our internal control over financial reporting.  The annual
report of management on the effectiveness of internal control over financial
reporting is set forth below.





94





MANAGEMENT’S
REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING






The
management of Sound Financial, Inc. is responsible for establishing and
maintaining adequate internal control over financial reporting, as such term is
defined in Exchange Act Rule 13a-15(f).  The Company’s internal
control over financial reporting is a process designed to provide reasonable
assurance to the Company’s management and board of directors regarding the
reliability of financial reporting and the preparation of the financial
statements for external purposes in accordance with accounting principles
generally accepted in the United States of America.




The
Company’s internal control over financial reporting includes those policies and
procedures that (i) pertain to the maintenance of records that, in reasonable
detail, accurately and fairly reflect the transactions and dispositions of the
assets of the Company; (ii) provide reasonable assurance that transactions are
recorded as necessary to permit preparation of financial statements in
accordance with accounting principles generally accepted in the United States of
America, and that receipts and expenditures of the Company are being made only
in accordance with authorizations of management and directors of the Company;
and (iii) provide reasonable assurance regarding prevention or timely detection
of unauthorized acquisition, use, or disposition of the Company’s assets that
could have a material effect on the financial statements.




Because
of its inherent limitations, internal controls over financial reporting may not
prevent or detect misstatements.  All internal control systems, no
matter how well designed, have inherent limitations, including the possibility
of human error and the circumvention of overriding
controls.  Accordingly, even effective internal control over financial
reporting can provide only reasonable assurance with respect to financial
statement preparation.  Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.




Our
management assessed the effectiveness of the Company’s internal control over
financial reporting as of December 31, 2009.  In making this
assessment, it used the criteria set forth by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO) in Internal Control-Integrated
Framework.  Based on our assessment, we concluded that, as of December
31, 2009, the Company’s internal control over financial reporting was effective
based on those criteria.




This
annual report does not include an attestation of our independent registered
public accounting firm regarding internal controls over financial
reporting.  Management’s report was not subject to attestation by our
independent registered public accounting firm pursuant to temporary rules of the
Securities and Exchange Commission that permit the Company to provide only
management’s report in this annual report.





(c)Changes in Internal Controls
over Financial Reporting




There
were no changes in our internal controls over financial reporting (as defined in
Rule 13a-15(f) under the Exchange Act) that occurred during the year ended
December 31, 2009, that have materially affected, or is reasonably likely to
materially affect, our internal control over financial reporting.







Item
9B.       Other Information






None.





95







PART
III







Item
10.                      Directors,
Executive Officers and Corporate Governance




Directors




Information
concerning the Company’s directors is incorporated herein by reference from the
Company’s definitive proxy statement for its Annual Meeting of Shareholders to
be held in May 2010, except for information contained under the heading “Report
of the Audit Committee,” a copy of which will be filed not later than 120 days
after the close of the fiscal year.







Executive
Officers




Information
concerning the executive officers of the Company and the Bank is incorporated
herein by reference from the Company’s definitive proxy statement for its Annual
Meeting of Shareholders to be held in May 2010, except for information contained
under the heading “Report of the Audit Committee,” a copy of which will be filed
not later than 120 days after the close of the fiscal year.







Audit
Committee Matters and Audit Committee Financial Expert




The Board
of Directors of the Company has a standing Audit Committee, which has been
established in accordance with Section 3(a)(58)(A) of the Exchange
Act.  The members of that committee are Directors McMullen (chair),
Haddad, Carney and Jones, all of whom are considered independent under Nasdaq
listing standards.  The Board of Directors has determined that Ms.
Jones is an “audit committee financial expert” as defined in applicable SEC
rules.  Additional information concerning the Audit Committee is
incorporated herein by reference from the Company’s definitive proxy statement
for its Annual Meeting of Shareholders to be held in May 2010, except for
information contained under the heading “Report of the Audit Committee,” a copy
of which will be filed not later than 120 days after the close of the fiscal
year.







Section
16(a) Beneficial Ownership Reporting Compliance




Section
16(a) of the Exchange Act requires the Company’s directors and executive
officers, and persons who own more than 10% of a registered class of the
Company’s equity securities, to file with the SEC reports of ownership and
reports of changes in ownership of common stock and other equity securities of
the Company.  Officers, directors and greater than 10% stockholders
are required by SEC regulation to furnish the Company with copies of all Section
16(a) forms they file.




On
November 17, 20, 23 and 24, 2009, Senior Vice President Scott V. Boyer purchased
shares of the Company’s stock.  Due to an administrative error, Form
4’s were not filed within two business days of these purchases.  A
Form 5 was filed for Mr. Boyer on January 20, 2010 to report these
purchases.  To the Company’s knowledge, based solely on a review of
the copies of such reports furnished to the Company and written representations
that no other reports were required during the fiscal year ended December 31,
2009, all Section 16(a) filing requirements applicable to its officers,
directors and greater than 10% beneficial owners were complied with, except for
the late filings regarding Mr. Boyer.





96







Code
of Ethics






The
Company adopted a written Code of Ethics based upon the standards set forth
under Item 406 of Regulation S-K of the Securities Exchange Act.  The
Code of Ethics applies to all of the Company’s directors, officers and
employees.  A copy of the Company’s Code of Ethics was filed as
Exhibit 14 to this Annual Report on Form 10-K for the year ended December 31,
2008.  A copy of the Code of Ethics is available on our website at
www.soundcb.com
under “Investor Relations – Governance” or free of charge from the Company by
writing to our Corporate Secretary at Sound Financial, Inc., 2005 5th Avenue,
Suite 200, Seattle, Washington, 98121 or by calling (206) 448-0884.







Nomination
Procedures




There
have been no material changes to the procedures by which shareholders may
recommend nominees to the Company’s Board of Directors.







Item
11.        Executive
Compensation




Information
concerning executive compensation is incorporated herein by reference from the
Company’s definitive proxy statement for its Annual Meeting of Shareholders to
be held in May 2010, except for information contained under the heading “Report
of the Audit Committee,” a copy of which will be filed not later than 120 days
after the close of the fiscal year.







Item
12.        Security Ownership of Certain
Beneficial Owners and Management and Related Stockholder Matters




Information
concerning security ownership of certain beneficial owners and management is
incorporated herein by reference from the Company’s definitive proxy statement
for its Annual Meeting of Shareholders to be held in May 2010, except for
information contained under the heading “Report of the Audit Committee,” a copy
of which will be filed not later than 120 days after the close of the fiscal
year.




Equity Compensation Plan
Information.  The following table sets forth information as of
December 31, 2009, with respect to compensation plans under which shares of
common stock were issued.




Plan
      Category
            
            Number
      of securities
              to
      be issued upon exercise of
              outstanding
      options, warrants and rights
            
            Weighted
      average
              exercise
      price of
              outstanding
      options,
              warrants
      and rights
            
            Number
      of securities
              remaining
      available
              for
      future issuance
              under
      equity
              compensation
      planEquity
      Incentive Plan approved
              by
      Security Holders
            
            108,398
            
            $7.925
            
            41,807(1)Equity
      Incentive Plan Not
              Approved
      by Security Holders
            
            ---
            
            ---
            
            ---





(1)
            Consists
      of stock options and stock appreciation rights covering up to 36,057
      shares of common stock and restricted stock and restricted stock units
      covering up to 5,750 shares of common
stock.











97





Item
13.       Certain Relationships and Related
Transactions, and Director Independence




Information
concerning certain relationships and related transactions, our independent
directors and our audit and nominating committee charters is incorporated herein
by reference from the Company’s definitive proxy statement for its Annual
Meeting of Shareholders to be held in May 2010, except for information contained
under the heading “Report of the Audit Committee,” a copy of which will be filed
not later than 120 days after the close of the fiscal year.







Item
14.       Principal Accounting Fees and
Services




Information
concerning principal accountant fees and services is incorporated herein by
reference from the Company’s definitive proxy statement for its Annual Meeting
of Shareholders to be held in May 2010, except for information contained under
the heading “Report of the Audit Committee,” a copy of which will be filed not
later than 120 days after the close of the fiscal year.







PART
IV




Item
15.       Exhibits and Financial Statement
Schedules




(a)(1) List of Financial
Statements




The
following are contained in Item 8 of this Form 10-K:





Report
      of Independent Registered Public Accounting FirmConsolidated
      Balance Sheets at December 31, 2009 and 2008Consolidated
      Statements of Operations for the Years Ended December 31, 2009 and
      2008Consolidated
      Statements of Stockholders' Equity for the Years Ended December
      31,
              2009,
      and 2008Consolidated
      Statements of Cash Flows for the Years Ended December 31, 2009 and
      2008Notes
      to Consolidated Financial
Statements





(a)(2) List of Financial
Statement Schedules:




All
financial statement schedules have been omitted as the information is not
required under the related instructions or is not applicable.





98





(a)(3) List of
Exhibits:


Exhibit
              Number
            
            Document
            
            Reference
      to
              Prior
      Filing or
              Exhibit
      Number
              Attached
              Hereto3.1
            
            Charter
            
            *3.2
            
            Bylaws
            
            **4
            
            Instruments
      defining the rights of security holders, including
indentures:
              Form
      of Sound Financial, Inc. Common Stock Certificate
            
            **9
            
            Voting
      Trust Agreement
            
            None10.1
            
            Employment
      Agreement with Laura Lee Stewart
            
            *10.2
            
            Executive
      Long Term Compensation Agreement with Laura Lee Stewart
            *10.3
            
            Executive
      Long Term Compensation Agreement with Patricia Floyd
            
            *10.4
            
            Sound
      Incentive Compensation Achievement Plan
            
            *10.5
            
            Summary
      of Annual Bonus Plan
            
            *10.6
            
            Summary
      of Quarterly Bonus Plan
            
            *10.7
            
            Director
      Fee Arrangements for 2009
            
            10.710.8
            
            Sound
      Financial, Inc. 2008 Equity Incentive Plan
            
            ++10.9
            
            Form
      of Incentive Stock Option Agreement under the 2008 Equity Incentive
      Plan
            
            +10.10
            
            Form
      of Non-Qualified Stock Option Agreement under the 2008 Equity Incentive
      Plan
            
            +10.11
            
            Form
      of Restricted Stock Agreement under the 2008 Equity Incentive
      Plan
            
            +10.12
            
            Purchase
      and Assumption Agreement dated April 24, 2009, between Sound Community
      Bank and 1st
      Security Bank of Washington (Port Angeles Office)
            
            +++10.13
            
            Purchase
      and Assumption Agreement dated June 23, 2009, between Sound Community Bank
      and 1st
      Security Bank of Washington (Tacoma Office)
            
            +++10.14
            
            Employment
      Agreement with Scott Boyer dated November 1, 2009
            
            ++++10.15
            
            Employment
      Agreement with Marlene Price dated November 1, 2009
            
            ++++10.16
            
            Employment
      Agreement with Matthew Moran dated November 1, 2009
            
            ++++10.17
            
            Employment
      Agreement with Matthew Deines dated November 1, 2009
            
            ++++11
            
            Statement
      re computation of per share earnings
            
            None14
            
            Code
      of Business Conduct and Ethics
            
            ***16
            
            Letter
      re change in certifying accountant
            
            None18
            
            Letter
      re change in accounting principles
            
            None21
            
            Subsidiaries
      of the registrant
            
            *22
            
            Published
      report regarding matters submitted to vote of security
    holders
            
            None23
            
            Consents
      of Independent Registered Public Accounting Firm - Moss Adams
      LLP
            
            2324
            
            Power
      of Attorney
            
            None31.1
            
            Rule
      13(a)-14(a) Certification (Chief Executive Officer)
            
            31.131.2
            
            Rule
      13(a)-14(a) Certification (Chief Financial Officer)
            
            31.232
            
            Section
      1350 Certification
            
            32


*
            Filed
      as an exhibit to the Company’s Form SB-2 registration statement filed on
      September 20, 2007 (File No. 333-146196) pursuant to Section 5 of the
      Securities Act of 1933 and incorporated herein by reference in accordance
      with Item 601 of Regulation S-K.


**
            Filed
      as an exhibit to Pre-Effective Amendment No. 1 to the Company’s Form SB-2
      registration statement filed on November 2, 2007 (File No. 333-146196)
      pursuant to Section 5 of the Securities Act of 1933 and incorporated
      herein by reference in accordance with Item 601 of Regulation
      S-K.


***
            Filed
      as an exhibit to the Company’s Form 10-K filed on March 31, 2008 and
      incorporated herein by reference in accordance with Item 601 of Regulation
      S-K.


+
            Filed
      as an Exhibit to the Company’s Form 8-K filed on January 29, 2009 and
      incorporated herein by reference.


++
            Filed
      as an exhibit to the Company’s Form 10-K filed on March 31, 2009 and
      incorporated herein by reference.


+++
            Filed
      as an exhibit to the Company’s Form 8-K filed on June 29, 2009 and
      incorporated herein by reference.


++++
            Filed
      a an exhibit to the Company’s Form 8-K filed on November 5, 2009 and
      incorporated herein by reference.


(b)  Exhibits-
Included, see list in (a)(3).





(c)  Financial Statements
Schedules - None





99








SIGNATURES






Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
1934, the Registrant has duly caused this report to be signed on its behalf by
the undersigned, thereunto duly authorized.


Sound
      Financial, Inc.Date:  March
      31, 2010
            By:
            /s/  Laura
      Lee StewartLaura
      Lee Stewart, President and Chief Executive OfficerDuly
      Authorized Representative)







Pursuant
to the requirements of the Securities Exchange Act of 1934, this report has been
signed below by the following persons on behalf of the Registrant and in the
capacities and on the dates indicated.


/s/  Laura
      Lee Stewart
            
            /s/  Tyler
      K. MyersLaura
      Lee Stewart, President and Director
            
            Tyler
      K. Myers, Chairman of the Board(Principal
      Executive Officer)Date:  March
      31, 2010
            
            Date:  March
      31, 2010/s/  David
      S. Haddad, Jr.
            
            /s/  Robert
      F. CarneyDavid
      S. Haddad, Jr., Director
            
            Robert
      F. Carney, DirectorDate:  March
      31, 2010
            
            Date:  March
      31, 2010/s/  Debra
      Jones
            
            /s/  Milton
      L. McMullenDebra
      Jones, Director
            
            Milton
      L. McMullen, DirectorDate:  March
      31, 2010
            
            Date:  March
      31, 2010/s/  Rogelio
      Riojas
            
            /s/  James
      E. SweeneyRogelio
      Riojas, Director
            
            James
      E. Sweeney, DirectorDate:  March
      31, 2010
            
            Date:  March
      31, 2010/s/  Matthew
      P. DeinesMatthew
      P. Deines, Executive Vice Presidentand
      Chief Financial Officer(Principal
      Financial and Accounting Officer)Date:  March
      31, 2010








100





INDEX
TO EXHIBITS











Number
            Description10.7
            Director
      Fee Arrangements for 201023
            Consent
      of Independent Registered Public Accounting Firm - Moss Adams
      LLP31.1
            Rule
      13(a)-14(a) Certification (Chief Executive Officer)31.2
            Rule
      13(a)-14(a) Certification (Chief Financial Officer)32
            Section
      1350 Certification