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, 2008OR[  ]
            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
              (Address
      of principal executive offices)
            98121
              (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 check mark if
the registrant is a well-known seasoned issuer, as defined in Rule 405 of the
Securities Act.  YES [   ]    NO
[X]




Indicate by check mark 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 check mark
whether the registrant (1) has filed all reports required to be filed by Section
13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12
months (or for such shorter period that the registrant was required to file such
reports), and (2) has been subject to such filing requirements for the past 90
days.   YES [X]  NO
[   ]




Indicate by check mark 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. [   ]




Indicate by check mark
whether the registrant is a large accelerated filer, an accelerated filer, a
non-accelerated filer or a smaller reporting company.  See definition
of “accelerated filer,” “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 check mark 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,
2008, the last business day of the registrant’s most recently completed second
fiscal quarter, was $10.5 million.




As of
March 17, 2009, 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 2009 Annual
Meeting of Shareholders.








PART
I




Item
1.                      Business




General




Sound
Financial, Inc. (“Sound Financial” or the “Company”) was incorporated under
federal law on January 8, 2008, to hold all of the stock of Sound Community Bank
(sometimes referred to herein as the “Bank”).  Sound Financial is a
savings and loan holding company and is subject to regulation by the Office of
Thrift Supervision.  On an unconsolidated basis at December 31, 2008,
Sound Financial’s assets consisted of all of the outstanding shares of common
stock of Sound Community Bank, $2.4 million in cash, other assets of
$37,000 and a loan to the Sound Financial employee stock ownership
plan.  Sound Financial had $74,000 of other liabilities at December
31, 2008.  The words “we,” “our” and “us” refer to Sound Financial and
Sound Community Bank on a consolidated basis.





Sound
Financial sold 1,297,148 shares of common stock to investors at $10.00 per share
in a subscription offering, which closed on January 8, 2008.  Those
shares constitute 44% of the outstanding shares of common stock of Sound
Financial.  In connection with the closing of the offering, 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
Financial raised $12,971,480 in its public offering and after paying $1,005,000
in offering expenses (as of the closing date), it contributed $8,000,000 to the
Bank, lent $1,155,600 to fund its employee stock ownership plan’s purchase of
shares in the offering and retained the remaining $2,792,000 for working
capital.  The MHC reorganization and stock offering were completed in
January 8, 2008; accordingly all information prior to that date relates solely
to Sound Community Bank.




At
December 31, 2008, the Company had total assets of $293.5 million, deposits of
$222.7 million and stockholders’ equity of $26.1 million.  Our
executive offices are located at 2005 5th Avenue, Seattle Washington
98121.  The shares of Sound Financial are traded on the
Over-the-Counter Electronic Bulletin Board under the
symbol "SNFL".




Management
of Sound Financial and Sound Community Bank are substantially the same and Sound
Financial uses the offices of Sound Community Bank.  Sound Financial
utilizes the support staff of Sound Community Bank from time to time and pays
Sound Community Bank for this expense.  If Sound Financial expands or
changes its business in the future, we may hire our own employees.




Substantially
all of Sound Financial’s business is conducted through the Bank, 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”).


1




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, Sound
Community Bank 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 Bank became a
taxable organization.




The
Bank’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 $57.7 million and $39.8 million in
one- to four-family residential mortgage loans during the years ended December
31, 2008 and 2007, respectively.  During these same periods, we sold
$31.6 million and $25.6 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 havealsorelied 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 Bank’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 theyield 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 Bank’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.




Forward-Looking
Statements




This Form
10-K contains various forward-looking statements that are based on assumptions
and describe our future plans and strategies and our
expectations.  These forward-looking statements are generally
identified by words such as “believe,” “expect,” “intend,” “anticipate,”
“estimate,” “project,” or similar words.  Our ability to predict
results or the actual effect of future plans or strategies is
uncertain.  Factors which could cause actual results to differ
materially from those estimated include, but are not limited to, changes in
interest rates, general economic conditions, legislative/regulatory changes,
monetary and fiscal policies of the U.S. Government, including policies of the
U.S. Treasury and the Federal Reserve Board, the quality and composition of our
loan and investment portfolios, demand for our loan products, deposit flows, our
operating expenses, competition, demand for financial services in our market
areas and accounting principles and guidelines.  These risks and
uncertainties should be




2




considered
in evaluating forward-looking statements, and you should not rely too much on
these 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.






Difficult
market conditions and economic trends have adversely affected our industry and
our business. Federal laws regulations and programs have been enacted to address
these difficult market and economic conditions and to stabilize the U.S. banking
system. See Item 7 of this form 10K.





Market
Area






Our
primary market area is the Puget Sound region.  We are headquartered
in Seattle, Washington and have five 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 0.18%.  Our fifth office, in Clallam
County, has 4.7% of the deposits in that market.




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 performed well over the last few years, spurred on by
strong growth despite the downsizing of one of its major employers, the Boeing
Company, during the past decade.  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 2008, the Seattle MSA reported an unemployment rate of 6.3%,
as compared to the national average of 7.1%, 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.












3


Lending
Activities






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





2008
                  
                  
                  2007
                  
                  
                  2006
                  
                  
                  2005
                  
                  
                  2004Amount
                  
                  
                  Percent
                  
                  
                  Amount
                  
                  
                  Percent
                  
                  
                  Amount
                  
                  
                  Amount
                  
                  
                  Percent
                  
                  
                  Amount
                  
                  
                  Percent
                  
                  
                  AmountReal
      estate loans:One-
      to four-family
                  
                  $
                  90,863
                  
                  
                  
                  34.33
                  %
                  
                  $
                  84,788
                  
                  
                  
                  38.37
                  %
                  
                  $
                  86,102
                  
                  
                  
                  41.60
                  %
                  
                  $
                  75,554
                  
                  
                  
                  39.34
                  %
                  
                  $
                  67,599
                  
                  
                  
                  42.55
                  %Home
      equity
                  
                  
                  54,557
                  
                  
                  
                  20.61
                  
                  
                  
                  45,374
                  
                  
                  
                  20.53
                  
                  
                  
                  39,302
                  
                  
                  
                  18.99
                  
                  
                  
                  28,534
                  
                  
                  
                  14.86
                  
                  
                  
                  23,841
                  
                  
                  
                  15.01Commercial
                  
                  
                  48,730
                  
                  
                  
                  18.41
                  
                  
                  
                  25,013
                  
                  
                  
                  11.32
                  
                  
                  
                  17,501
                  
                  
                  
                  8.46
                  
                  
                  
                  15,548
                  
                  
                  
                  8.10
                  
                  
                  
                  15,042
                  
                  
                  
                  9.47Construction
      or development
                  
                  
                  12,220
                  
                  
                  
                  4.62
                  
                  
                  
                  8,622
                  
                  
                  
                  3.90
                  
                  
                  
                  9,459
                  
                  
                  
                  4.57
                  
                  
                  
                  7,777
                  
                  
                  
                  4.05
                  
                  
                  
                  5,163
                  
                  
                  
                  3.25Total real estate
      loans
                  
                  
                  206,370
                  
                  
                  
                  77.97
                  
                  
                  
                  163,797
                  
                  
                  
                  74.12
                  
                  
                  
                  152,364
                  
                  
                  
                  73.62
                  
                  
                  
                  127,413
                  
                  
                  
                  66.35
                  
                  
                  
                  111,645
                  
                  
                  
                  70.27Consumer
      loans:Manufactured
      homes
                  
                  
                  22,723
                  
                  
                  
                  8.58
                  
                  
                  
                  22,495
                  
                  
                  
                  10.18
                  
                  
                  
                  19,785
                  
                  
                  
                  9.56
                  
                  
                  
                  16,648
                  
                  
                  
                  8.67
                  
                  
                  
                  9,702
                  
                  
                  
                  6.11Automobile
                  
                  
                  10,080
                  
                  
                  
                  3.81
                  
                  
                  
                  15,078
                  
                  
                  
                  6.82
                  
                  
                  
                  17,272
                  
                  
                  
                  8.35
                  
                  
                  
                  18,138
                  
                  
                  
                  9.44
                  
                  
                  
                  15,964
                  
                  
                  
                  10.05Credit
      Card
                  
                  
                  ---
                  
                  
                  
                  ---
                  
                  
                  
                  ---
                  
                  
                  
                  ---
                  
                  
                  
                  ---
                  
                  
                  
                  ---
                  
                  
                  
                  12,196
                  
                  
                  
                  6.35
                  
                  
                  
                  11,747
                  
                  
                  
                  7.39Other
                  
                  
                  7,871
                  
                  
                  
                  2.97
                  
                  
                  
                  8,818
                  
                  
                  
                  3.99
                  
                  
                  
                  9,932
                  
                  
                  
                  4.79
                  
                  
                  
                  6,478
                  
                  
                  
                  3.37
                  
                  
                  
                  5,223
                  
                  
                  
                  3.29Total consumer
      loans
                  
                  
                  40,674
                  
                  
                  
                  15.37
                  
                  
                  
                  46,391
                  
                  
                  
                  20.99
                  
                  
                  
                  46,989
                  
                  
                  
                  22.71
                  
                  
                  
                  53,460
                  
                  
                  
                  27.84
                  
                  
                  
                  42,636
                  
                  
                  
                  26.84Commercial
      business loans
                  
                  
                  17,668
                  
                  
                  
                  6.67
                  
                  
                  
                  10,803
                  
                  
                  
                  4.89
                  
                  
                  
                  7,600
                  
                  
                  
                  3.67
                  
                  
                  
                  11,168
                  
                  
                  
                  5.82
                  
                  
                  
                  4,588
                  
                  
                  
                  2.89Total
      loans
                  
                  
                  264,712
                  
                  
                  
                  100.00
                  %
                  
                  
                  220,991
                  
                  
                  
                  100.00
                  %
                  
                  
                  206,953
                  
                  
                  
                  100.00
                  %
                  
                  
                  192,041
                  
                  
                  
                  100.00
                  %
                  
                  
                  158,869
                  
                  
                  
                  100.00
                  %Less:Deferred
      fees and discounts
                  
                  
                  43
                  
                  
                  
                  
                  
                  
                  
                  (65
                  )
                  
                  
                  
                  
                  
                  
                  12
                  
                  
                  
                  
                  
                  
                  
                  185
                  
                  
                  
                  
                  
                  
                  
                  131Loans
      held for sale
                  
                  
                  956
                  
                  
                  
                  
                  
                  
                  
                  822
                  
                  
                  
                  
                  
                  
                  
                  1,307
                  
                  
                  
                  
                  
                  
                  
                  1,069
                  
                  
                  
                  
                  
                  
                  
                  ---Allowance
      for losses
                  
                  
                  1,306
                  
                  
                  
                  
                  
                  
                  
                  828
                  
                  
                  
                  
                  
                  
                  
                  822
                  
                  
                  
                  
                  
                  
                  
                  1,321
                  
                  
                  
                  
                  
                  
                  
                  1,033Total loans,
      net
                  
                  $
                  262,407
                  
                  
                  
                  
                  
                  
                  $
                  219,406
                  
                  
                  
                  
                  
                  
                  $
                  204,812
                  
                  
                  
                  
                  
                  
                  $
                  189,466
                  
                  
                  
                  
                  
                  
                  $
                  157,705




















4












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.








2008
              
              
              2007
              
              
              2006
              
              
              2005
              
              
              2004Amount
              
              
              Percent
              
              
              Amount
              
              
              Percent
              
              
              Amount
              
              
              Amount
              
              
              Percent
              
              
              Amount
              
              
              Percent
              
              
              AmountFixed-
      rate loans:Real
      estate loans:One- to
      four-family(1)
              
              $
              72,439
              
              
              
              27.37
              %
              
              $
              66,335
              
              
              
              30.02
              %
              
              $
              74,159
              
              
              
              35.83
              %
              
              $
              69,100
              
              
              
              35.98
              %
              
              $
              63,725
              
              
              
              40.11
              %Home
      equity
              
              
              15,613
              
              
              
              5.90
              
              
              
              17,814
              
              
              
              8.05
              
              
              
              18,159
              
              
              
              8.77
              
              
              
              7,655
              
              
              
              3.99
              
              
              
              6,304
              
              
              
              3.97Commercial
              
              
              26,035
              
              
              
              9.84
              
              
              
              17,250
              
              
              
              7.81
              
              
              
              12,000
              
              
              
              5.80
              
              
              
              11,088
              
              
              
              5.77
              
              
              
              7,813
              
              
              
              4.92Construction
      or development
              
              
              10,323
              
              
              
              3.90
              
              
              
              5,583
              
              
              
              2.53
              
              
              
              7,056
              
              
              
              3.41
              
              
              
              3,461
              
              
              
              1.80
              
              
              
              1,788
              
              
              
              1.13Total real estate
      loans
              
              
              124,410
              
              
              
              47.01
              
              
              
              106,982
              
              
              
              48.41
              
              
              
              111,374
              
              
              
              53.82
              
              
              
              91,304
              
              
              
              47.54
              
              
              
              79,630
              
              
              
              50.12Manufactured
      homes
              
              
              22,723
              
              
              
              8.58
              
              
              
              22,495
              
              
              
              10.18
              
              
              
              19,785
              
              
              
              9.56
              
              
              
              16,648
              
              
              
              8.67
              
              
              
              9,702
              
              
              
              6.11Automobile
              
              
              10,080
              
              
              
              3.81
              
              
              
              15,078
              
              
              
              6.82
              
              
              
              17,272
              
              
              
              8.35
              
              
              
              18,138
              
              
              
              9.44
              
              
              
              15,964
              
              
              
              10.05Credit
      card
              
              
              ---
              
              
              
              ---
              
              
              
              ---
              
              
              
              ---
              
              
              
              ---
              
              
              
              ---
              
              
              
              3,138
              
              
              
              1.63
              
              
              
              5,595
              
              
              
              3.52Other
      consumer
              
              
              6,168
              
              
              
              2.33
              
              
              
              7,119
              
              
              
              3.22
              
              
              
              9,148
              
              
              
              4.42
              
              
              
              5,755
              
              
              
              3.00
              
              
              
              4,421
              
              
              
              2.78Commercial
      business loans
              
              
              7,551
              
              
              
              2.85
              
              
              
              5,539
              
              
              
              2.51
              
              
              
              4,121
              
              
              
              1.99
              
              
              
              3,750
              
              
              
              1.95
              
              
              
              1,674
              
              
              
              1.05Total fixed-rate
      loans
              
              
              46,522
              
              
              
              17.57
              
              
              
              157,213
              
              
              
              71.14
              
              
              
              161,700
              
              
              
              78.13
              
              
              
              138,733
              
              
              
              72.24
              
              
              
              116,986
              
              
              
              73.64Adjustable-
      rate loans:Real
      estate loans:One-
      to four-family
              
              
              18,424
              
              
              
              6.96
              
              
              
              18,453
              
              
              
              8.35
              
              
              
              11,942
              
              
              
              5.77
              
              
              
              6,453
              
              
              
              3.36
              
              
              
              3,875
              
              
              
              2.44Home
      equity
              
              
              38,944
              
              
              
              14.71
              
              
              
              27,560
              
              
              
              12.47
              
              
              
              21,143
              
              
              
              10.22
              
              
              
              20,879
              
              
              
              10.87
              
              
              
              17,537
              
              
              
              11.04Commercial
              
              
              22,695
              
              
              
              8.57
              
              
              
              7,764
              
              
              
              3.51
              
              
              
              5,502
              
              
              
              2.66
              
              
              
              4,460
              
              
              
              2.32
              
              
              
              7,228
              
              
              
              4.55Construction
      or development
              
              
              1,897
              
              
              
              0.72
              
              
              
              3,039
              
              
              
              1.38
              
              
              
              2,403
              
              
              
              1.16
              
              
              
              4,316
              
              
              
              2.25
              
              
              
              3,375
              
              
              
              2.12Total real estate
      loans
              
              
              81,960
              
              
              
              30.96
              
              
              
              56,816
              
              
              
              25.71
              
              
              
              40,990
              
              
              
              19.81
              
              
              
              36,108
              
              
              
              18.80
              
              
              
              32,015
              
              
              
              20.15Credit
      card
              
              
              ---
              
              
              
              ---
              
              
              
              ---
              
              
              
              ---
              
              
              
              ---
              
              
              
              ---
              
              
              
              9,058
              
              
              
              4.72
              
              
              
              6,152
              
              
              
              3.87Other
      consumer
              
              
              1,703
              
              
              
              0.64
              
              
              
              1,698
              
              
              
              0.77
              
              
              
              784
              
              
              
              0.38
              
              
              
              724
              
              
              
              0.38
              
              
              
              802
              
              
              
              0.50Commercial
      business loans
              
              
              10,117
              
              
              
              3.82
              
              
              
              5,264
              
              
              
              28.86
              
              
              
              3,479
              
              
              
              1.68
              
              
              
              7,418
              
              
              
              3.86
              
              
              
              2,914
              
              
              
              1.83Total
      adjustable-rate loans
              
              
              11,820
              
              
              
              4.46
              
              
              
              63,778
              
              
              
              28.86
              
              
              
              45,253
              
              
              
              21.87
              
              
              
              53,308
              
              
              
              27.76
              
              
              
              41,883
              
              
              
              26.36Total
      loans
              
              
              264,712
              
              
              
              100.00
              %
              
              
              220,991
              
              
              
              100.00
              %
              
              
              206,953
              
              
              
              100.00
              %
              
              
              192,041
              
              
              
              100.00
              %
              
              
              158,869
              
              
              
              100.00
              %Less:Deferred
      fees and discounts
              
              
              43
              
              
              
              
              
              
              
              (65
              )
              
              
              
              
              
              
              12
              
              
              
              
              
              
              
              185
              
              
              
              
              
              
              
              131Loans
      held for sale
              
              
              956
              
              
              
              
              
              
              
              822
              
              
              
              
              
              
              
              1,307
              
              
              
              
              
              
              
              1,069
              
              
              
              
              
              
              
              ---Allowance
      for losses
              
              
              1,306
              
              
              
              
              
              
              
              828
              
              
              
              
              
              
              
              822
              
              
              
              
              
              
              
              1,321
              
              
              
              
              
              
              
              1,033Total loans,
      net
              
              $
              262,407
              
              
              
              
              
              
              $
              219,406
              
              
              
              
              
              
              $
              204,812
              
              
              
              
              
              
              $
              189,466
              
              
              
              
              
              
              $
              157,705





___________________________


(1) Includes
30-year loans with a one-time rate adjustment five to seven years after
origination, which at December 31, 2008, totaled $32.9 million, or 45.4% of our
fixed-rate residential mortgages.


5







The
following schedule illustrates the contractual maturity of our loan portfolio at
December 31, 2008.  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 MortgagesOne-
      to Four-
                Family
              
              
              Home Equity Loans
              
              
              Commercial
              
              
              Construction
      or
                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)2009(1)
              
              $
              2,047
              
              
              
              5.65
              %
              
              $
              406
              
              
              
              6.91
              %
              
              $
              5,496
              
              
              
              7.54
              %
              
              $
              6,639
              
              
              
              7.21
              %
              
              $
              1,533
              
              
              
              12.20
              %
              
              $
              9,609
              
              
              
              5.83
              %
              
              $
              25,730
              
              
              
              6.93
              %2010
              
              
              6,145
              
              
              
              4.77
              
              
              
              239
              
              
              
              5.00
              
              
              
              505
              
              
              
              7.37
              
              
              
              207
              
              
              
              6.60
              
              
              
              1,544
              
              
              
              7.67
              
              
              
              1,085
              
              
              
              7.73
              
              
              
              9,725
              
              
              
              5.742011
              
              
              3,621
              
              
              
              5.71
              
              
              
              833
              
              
              
              5.06
              
              
              
              542
              
              
              
              7.03
              
              
              
              50
              
              
              
              6.75
              
              
              
              2,928
              
              
              
              7.59
              
              
              
              777
              
              
              
              8.11
              
              
              
              8,751
              
              
              
              6.582012
              
              
              6,782
              
              
              
              6.05
              
              
              
              478
              
              
              
              5.40
              
              
              
              3,000
              
              
              
              6.89
              
              
              
              112
              
              
              
              9.27
              
              
              
              3,688
              
              
              
              8.43
              
              
              
              1,278
              
              
              
              7.78
              
              
              
              15,338
              
              
              
              6.932013
      to 2015
              
              
              15,042
              
              
              
              7.01
              
              
              
              3,196
              
              
              
              5.51
              
              
              
              4,759
              
              
              
              7.09
              
              
              
              196
              
              
              
              6.63
              
              
              
              6,181
              
              
              
              7.78
              
              
              
              2,947
              
              
              
              6.99
              
              
              
              32,321
              
              
              
              7.022016
      to 2019
              
              
              9,845
              
              
              
              5.46
              
              
              
              24,800
              
              
              
              5.14
              
              
              
              24,119
              
              
              
              6.73
              
              
              
              774
              
              
              
              6.82
              
              
              
              4,347
              
              
              
              8.31
              
              
              
              1,481
              
              
              
              7.17
              
              
              
              65,366
              
              
              
              6.052020
      to 2023
              
              
              2,760
              
              
              
              5.60
              
              
              
              21,092
              
              
              
              6.22
              
              
              
              2,311
              
              
              
              6.84
              
              
              
              3,952
              
              
              
              7.22
              
              
              
              10,637
              
              
              
              9.07
              
              
              
              23
              
              
              
              7.38
              
              
              
              40,775
              
              
              
              7.052024
      and following
              
              
              44,621
              
              
              
              5.69
              
              
              
              3,513
              
              
              
              7.86
              
              
              
              7,998
              
              
              
              6.89
              
              
              
              290
              
              
              
              6.76
              
              
              
              9,816
              
              
              
              8.04
              
              
              
              468
              
              
              
              7.28
              
              
              
              66,706
              
              
              
              6.31Total
              
              $
              90,863
              
              
              
              5.85
              %
              
              $
              54,557
              
              
              
              5.77
              %
              
              $
              48,730
              
              
              
              6.90
              %
              
              $
              12,220
              
              
              
              7.17
              %
              
              $
              40,674
              
              
              
              8.44
              %
              
              $
              17,668
              
              
              
              6.53
              %
              
              $
              264,712
              
              
              
              6.53
              %


___________________________________________


(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, 2009, which have predetermined interest rates, is $158.8 million,
while the total amount of loans due after such date, which have floating or
adjustable interest rates is $80.2 million.







6













Lending
Authority.  The Senior Vice President – Lending Manager and our
Chief Executive Officer may approve unsecured loans up to $250,000. The Senior
Vice President – Lending Manager also may approve secured consumer loans and
residential mortgage and construction and development loans (excluding
commercial loans) up to $500,000; the lending authority for the Chief Executive
Officer includes limits for commercial loans. Our Chief Executive Officer may
approve unsecured loans up to $500,000 and secured loans up to $1.0
million.  Loans over the Chief Executive Officer’s authority of $1.0
million or loans otherwise outside our general underwriting guidelines must be
approved by the Board of Directors or a committee thereof.




At
December 31, 2008, the maximum amount under federal law that we could lend to
any one borrower and the borrower’s related entities was approximately $3.9
million.  Our five largest lending relationships are with commercial
borrowers and totaled $12,213,224 in the aggregate, or 4.62% of our $264,503,965
loan portfolio, at December 31, 2008. The largest relationship consists of $2.7
million in loans to a commercial real estate business, which is collateralized
by several parcels on the Washington state peninsula. The next four largest
lending relationships at December 31, 2008, were $2.5 million to an individual
collateralized with three parcels of commercial property and the accounts
receivable, equipment and a UCC-1 filing from his business; $2.4 million to a
land development company and the leased commercial real estate on the land, in
addition to a manufactured home park secured with the underlying real estate;
$2.4 million to an equipment leasing company, which is secured by receivables;
and $2.3 million to a business for the purchase of an apartment building,. All
of these loans were current as of December 31, 2008.  At December 31,
2008, we had no other lending relationships that exceeded $2.1
million.




One- to
Four-Family Real Estate Lending.  We originate loans secured by
first mortgages on one- to four-family residences primarily in our market
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 are also important sources of loan
originations.  Since converting from a credit union to a federal
mutual savings bank in 2003, we have expanded our target residential mortgage
market to include individuals who are not members, with an emphasis on
increasing the number and amount of residential real estate loan
originations.




A portion
of the one- to four-family loans we originate are funded by us and retained in
our portfolio and others are originated and 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 enhances our
interest rate risk, provides a stream of securing income that improves earnings,
enhances our 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 loan originations, including conforming fixed-rate
loans, on a servicing retained basis.  See “- Loan Originations,
Purchases, Sales, Repayments and Servicing.”  At December 31, 2008,
one- to four-family residential mortgage loans (including loans held for sale)
totaled $90.9 million, or 34.3%, of our gross loan portfolio, of which $72.4
million were fixed-rate loans and $18.4 million were adjustable rate
loans.




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 below 90%.  Second
mortgages on one- to four-family residences, whether owner occupied or not, are
made up to


7




100% 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 on a fixed-rate basis
and, to a lesser extent, an adjustable-rate basis (ARM), as customer demand
dictates.  Our pricing strategy for mortgage loans includes setting
interest rates that are competitive with other local financial institutions and
consistent with our asset/liability management objectives.  During the
year ended December 31, 2008, we originated $54.0 million of one- to four-family
fixed-rate mortgage loans and $3.7 million of one- to four-family ARM
loans.




Fixed-rate
loans secured by one- to four-family residences have contractual maturities of
up to 40 years and are generally fully amortizing, with payments due
monthly.  Currently, adjustable rate mortgages 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, increasing the potential
for default.  We have not experienced significant delinquencies in our
one- to four-family loan portfolio, including our ARM loans.  However,
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 Freddie Mac, 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 $169,000 at December 31,
2008.




Home Equity
Lending.  Our home equity
loans, consisting of fixed-rate loans and variable-rate lines of credit, have
been increasing in amount consistently over the past several
years.  At December 31, 2008, home equity lines of credit totaled
$38.9 million and home equity loans totaled $15.6 million, or 20.6% of our gross
loan portfolio. The lines of credit may be originated in amounts, together with
the amount of the existing first mortgage, of up to 100% of the value of the
property securing the loan (less any prior mortgage loans).  Home
equity lines of credit are originated for up to $400,000 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 ten-year
draw period and amounts may be reborrowed after payment at any time during the
draw period.  Once the draw period has lapsed, the payment is
amortized over a 15-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, 2008, unfunded commitments on these lines of
credit totaled $22.9 million.




Our
fixed-rate home equity loans are originated in amounts, together with the amount
of the existing first mortgage, of up to 100% of the appraised value of the
subject property for home equity loans.  These loans may have terms
for up to 20 years and are fully amortizing.


8


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, warehouses and office buildings located in
our market areas.  We have a limited amount of loans secured by
multi-family residences, which we include in our commercial real estate
portfolio.  At December 31, 2008, commercial real estate loans totaled
$48.7 million, or 18.4%, of our gross loan portfolio.




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 reprices 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.




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 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.




We
generally maintain insurance or tax escrows for loans secured by commercial real
estate.  In order to monitor the adequacy of cash flows on
income-producing properties, the borrower is required to provide 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 large 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,
2008, totaled $2.3 million and is secured by an apartment building that is being
converted to condominiums. At December 31, 2008, this loan was performing in
accordance with the terms of the notes.




Construction or
Development Lending.We 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, 2008, our construction and development loans totaled $12.2 million,
or 4.6%, of our gross loan portfolio.




Construction
loans to individuals and contractors for the construction and acquisition of
personal residences totaled $6.6 million, or 54.2 %, of our construction and
development portfolio.  At December 31, 2008, the unadvanced
portion of these construction loans totaled $1.8 million.




Our
construction loans generally provide for the payment of interest only during the
construction phase, which is typically up to 9 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, 2008, our largest residential
construction mortgage loan commitment was for $792,000; $602,000 of which had
been disbursed. This


9




loan was
performing according to its terms.  The average outstanding
residential construction loan balance was approximately $216,000 at December 31,
2008.




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, 2008, we had a total of $3.4 million in
development loans to builders and residential lot developers, with our largest
development loan being a $1 million loan. 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.  These loans are required to be
paid on an accelerated basis as the lots are sold, so that we are repaid before
all the lots are sold.




We have
done a limited amount of 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, 2008.




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 home, automobile, motorcycle, boat and other
recreational vehicle loans, student loans and loans secured by savings
deposits.  We also offer unsecured consumer loans.  We
originate our consumer loans primarily in our market areas.




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, 2008 was 8.71%, compared to 5.85% for
one- to four-family residential mortgages, including loans held for sale. At
December 31, 2008, these loans totaled $22.7 million, or 55.9% of our consumer
loans and 8.6% of 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.  Several manufactured housing parks in the
Puget Sound area are closing, though government requirements have slowed down
the process.  As


10




a result,
in addition to the cost of moving a manufactured home, it is difficult to find a
new location.  This can result in increased defaults and lower
recovery on repossession.  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, 2008, $52,000 or 0.23% of our manufactured home loans were
non-performing.




We make
loans on new and used automobiles.  Our automobile loan portfolio
totaled $10.1 million at December 31, 2008, or 24.8% of our consumer loan
portfolio and 3.8% 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, though the total loan-to-value may be 110% of the book
value with the difference applied to tax, licenses, title and mechanical
breakdown and gap insurance.  We follow our internal underwriting
guidelines in evaluating automobile loans, including credit
scoring.




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, 2008, totaled $7.9 million, or 3.0% 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 $50,000.  At December 31, 2008, unfunded
commitments on our unsecured lines of credit totaled $2.9 million.




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).




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
and other 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
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.


11




Commercial
Business Lending.  At December 31, 2008, commercial business
loans totaled $17.7 million, or 6.7%, 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 $2.9 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.




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, though
our ability to make commercial real estate and business loans was limited under
the OTS supervisory directive until it was terminated in August
2007.  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 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






12






residential
real estate loans sold by us are sold with servicing retained.  We
earned mortgage servicing income of $334,000, $315,000 and $310,000,
respectively, for the years ended December 31, 2008, 2007 and 2006. At December
31, 2008, we were servicing a $141.5 million portfolio of residential mortgage
loans for Fannie Mae.  Those servicing rights constituted a $920,000
asset on our books on that date, which is amortized in proportion to and over
the period of the net servicing income.These mortgage servicing
rights are periodically evaluated for impairment based on their fair value,
which takes into account the rates and potential prepayments of those sold loans
being serviced.  The fair value of our mortgage servicing rights at
December 31, 2008 was $863,000. See Note 5 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 $31.6 million, $25.6 million and $24.9 million of
these loans during the years ended December 31, 2008, 2007 and 2006,
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 2008, 2007 and 2006 were
$(16,000) $11,000 and ($10,000), respectively.




After
evaluating the benefits, costs and risks of servicing and maintaining our credit
card portfolio in early 2006, we decided to offer credit cards through a third
party provider.  In June 2006, we sold our $11.6 million VISA credit
card portfolio to that third party provider in connection with that change in
our credit card business.  The portfolio was sold without recourse at
a gain of $2.3 million, which significantly increased net income for the year
ended December 31, 2006.  We retained the servicing of that portfolio
through the end of 2006.


13


The
following table shows our loan origination, sale and repayment activities for
the periods indicated.  Approximately $9.8 million in loans were
purchased for the year ended December 31, 2008. There were no loans purchased
for the years ended December 31, 2007 and 2006.





For
      the year
                        ended
      December 31,2008
                      
                      
                      2007
                      
                      
                      2006(In
      thousands)Originations by
      type:Fixed-rate:One-
      to four-family real estate
                      
                      $
                      54,024
                      
                      
                      $
                      30,601
                      
                      
                      $
                      38,712Home
      equity
                      
                      
                      4,035
                      
                      
                      
                      5,768
                      
                      
                      
                      13,593Commercial
      real estate
                      
                      
                      13,072
                      
                      
                      
                      10,391
                      
                      
                      
                      1,035Construction
      and development
                      
                      
                      2,574
                      
                      
                      
                      2,531
                      
                      
                      
                      6,747Consumer
                      
                      
                      7,579
                      
                      
                      
                      12,012
                      
                      
                      
                      19,191Commercial
      business
                      
                      
                      5,212
                      
                      
                      
                      3,404
                      
                      
                      
                      1,669Total
      fixed-rate
                      
                      
                      86,496
                      
                      
                      
                      64,707
                      
                      
                      
                      80,947Adjustable
      rate:One-
      to four-family real estate(1)
                      
                      
                      3,658
                      
                      
                      
                      9,221
                      
                      
                      
                      6,982Home
      equity
                      
                      
                      13,547
                      
                      
                      
                      11,300
                      
                      
                      
                      7,879Commercial
      real estate
                      
                      
                      18,140
                      
                      
                      
                      5,081
                      
                      
                      
                      325Construction
      and development
                      
                      
                      1,128
                      
                      
                      
                      1,919
                      
                      
                      
                      1,748Consumer
                      
                      
                      151
                      
                      
                      
                      389
                      
                      
                      
                      191Commercial
      business
                      
                      
                      1,515
                      
                      
                      
                      2,793
                      
                      
                      
                      769Total
      adjustable-rate
                      
                      
                      38,139
                      
                      
                      
                      30,704
                      
                      
                      
                      17,894Total
      loans originated
                      
                      
                      124,635
                      
                      
                      
                      95,411
                      
                      
                      
                      98,841Purchases by
      type:Commercial
      real estate
                      
                      
                      9,731
                      
                      
                      
                      ---
                      
                      
                      
                      ---Sales and
      Repayments:One-
      to four-family real estate
                      
                      
                      31,552
                      
                      
                      
                      25,644
                      
                      
                      
                      26,221Consumer
                      
                      
                      ---
                      
                      
                      
                      ---
                      
                      
                      
                      11,602Total
      loans sold
                      
                      
                      31,552
                      
                      
                      
                      25,644
                      
                      
                      
                      37,823Total
      principal repayments
                      
                      
                      59,093
                      
                      
                      
                      55,728
                      
                      
                      
                      46,106Total
      reductions
                      
                      
                      90,645
                      
                      
                      
                      81,373
                      
                      
                      
                      83,929Net
      increase (decrease)
                      
                      $
                      43,721
                      
                      
                      $
                      14,038
                      
                      
                      $
                      14,912





(1)
            These
      loans include $1.9 million, $3.4 million and $2.8 million, respectively,
      of adjustable rate mortgage loan originations to employees at December 31,
      2008, 2007 and 2006.





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
servicing manager 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, a
servicing manager will 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.


14




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
commercial business loans and loans secured by commercial real estate 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 commercial loan officers to see that the necessary steps are taken to
collect delinquent loans.  In addition, management meets as needed 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
commercial 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, 2008.





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
              
              
              10
              
              
              $
              534
              
              
              
              0.59
              %
              
              
              2
              
              
              $
              258
              
              
              
              0.28
              %
              
              
              12
              
              
              $
              792
              
              
              
              0.87
              %Home
      Equity
              
              
              2
              
              
              
              108
              
              
              
              0.20
              
              
              
              6
              
              
              
              340
              
              
              
              0.62
              
              
              
              8
              
              
              
              448
              
              
              
              0.82Commercial
      Real Estate
              
              
              1
              
              
              
              187
              
              
              
              0.38
              
              
              
              2
              
              
              
              471
              
              
              
              0.97
              
              
              
              3
              
              
              
              658
              
              
              
              1.47Construction
      and Development
              
              
              1
              
              
              
              142
              
              
              
              1.16
              
              
              
              2
              
              
              
              59
              
              
              
              0.48
              
              
              
              3
              
              
              
              201
              
              
              
              1.16Consumer
              
              
              13
              
              
              
              35
              
              
              
              0.09
              
              
              
              2
              
              
              
              64
              
              
              
              0.16
              
              
              
              15
              
              
              
              99
              
              
              
              0.24Commercial
      Business
              
              
              2
              
              
              
              149
              
              
              
              0.84
              
              
              
              1
              
              
              
              60
              
              
              
              0.34
              
              
              
              3
              
              
              
              209
              
              
              
              1.18Total
              
              
              29
              
              
              $
              1,155
              
              
              
              0.44
              %
              
              
              15
              
              
              $
              1,252
              
              
              
              0.47
              %
              
              
              44
              
              
              $
              2,407
              
              
              
              0.91
              %








The
amount and number of delinquent loans increased as of December 31, 2008 (44
loans totaling $2.4 million) compared to December 31, 2007 (37 loans totaling
$1.5 million). At the end of 2007, delinquencies consisted of one-to-four family
mortgages, commercial real estate and consumer loans. At the end of 2008, 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 2008.






15






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.  Troubled
debt restructurings, which involve forgiving a portion of interest or principal
on any loans or making loans at a rate materially less than that of market
rates, as of December 31, 2008 were $454,000 and consisted of one boat loan, one
land loan and one single family mortgage loan.  Foreclosed assets
include assets acquired in settlement of loans, including two foreclosed
properties totaling $1.3 million, repossessed inventory from a commercial
business loan and a combination of repossessed automobile and manufactured home
loans.  The largest foreclosed property has a book value of $1 million
as of December 31, 2008. We do not expect to experience a material loss on any
of the foreclosed assets in our possession.





December
      31,2008
              
              
              2007
              
              
              2006
              
              
              2005
              
              
              2004(Dollars
      in thousands)Non-accruing
      loans:One-
      to four-family
              
              $
              258
              
              
              $
              256
              
              
              $
              132
              
              
              $
              ---
              
              
              $
              --Home
      equity
              
              
              340
              
              
              
              ---
              
              
              
              ---
              
              
              
              20
              
              
              
              ---Commercial
      Real Estate
              
              
              471
              
              
              
              ---
              
              
              
              ---
              
              
              
              ---
              
              
              
              ---Construction
      or Development
              
              
              59
              
              
              
              ---
              
              
              
              ---
              
              
              
              ---
              
              
              
              ---Consumer
              
              
              64
              
              
              
              162
              
              
              
              160
              
              
              
              109
              
              
              
              42Commercial
      Business
              
              
              60
              
              
              
              ---
              
              
              
              ---
              
              
              
              ---
              
              
              
              ---Total
              
              
              1,252
              
              
              
              418
              
              
              
              292
              
              
              
              129
              
              
              
              42Accruing
      loans delinquent more
                than 90
      days:One-
      to four-family
              
              
              ---
              
              
              
              ---
              
              
              
              ---
              
              
              
              129
              
              
              
              ---Home
      equity
              
              
              ---
              
              
              
              ---
              
              
              
              ---
              
              
              
              ---
              
              
              
              ---Consumer
              
              
              ---
              
              
              
              ---
              
              
              
              ---
              
              
              
              191
              
              
              
              10Commercial
      business
              
              
              ---
              
              
              
              ---
              
              
              
              ---
              
              
              
              ---
              
              
              
              ---Total
              
              
              ---
              
              
              
              ---
              
              
              
              ---
              
              
              
              320
              
              
              
              10Foreclosed
      assets:One-
      to four-family
              
              
              1,250
              
              
              
              817
              
              
              
              ---
              
              
              
              ---
              
              
              
              ---Commercial
      business
              
              
              190
              
              
              
              ---
              
              
              
              ---
              
              
              
              ---
              
              
              
              ---Consumer
              
              
              284
              
              
              
              35
              
              
              
              106
              
              
              
              ---
              
              
              
              ---Total
              
              
              1,724
              
              
              
              852
              
              
              
              106
              
              
              
              ---
              
              
              
              ---Total
      non-performing assets
              
              $
              2,976
              
              
              $
              1,270
              
              
              $
              398
              
              
              $
              449
              
              
              $
              52Total
      as a percentage of total assets
              
              
              1.01
              %
              
              
              0.54
              %
              
              
              0.18
              %
              
              
              0.22
              %
              
              
              0.03
              %







For the
year ended December 31, 2008, gross interest income which would have been
recorded had the non-accruing loans been current in accordance with their
original terms amounted to $56,000, which was included in interest income for
the year ended December 31, 2008.




Other Loans of
Concern.  In addition to the non-performing assets set forth in
the table above, as of December 31, 2008, there were 76 loans totaling $4.6
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.  The increase in loans of concern from $748,000 as of
December 31, 2007 reflects the declining economic conditions in 2008. These
loans have been considered in management’s determination of our allowance for
loan losses.  The largest loan relationship of concern at December 31,
2008, totaled $482,000 to an individual borrower for a loan secured by their
primary residence.


16




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, 2008, we had classified $8.3 million of our assets as substandard,
which represented a variety of outstanding loans, 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 31.7% of our equity capital and 2.57% of our
assets at December 31, 2008.  Classified assets totaled $852,000, or
5.3% of our equity capital and 0.4% of our assets at December 31,
2007.  Improvements in our credit administration procedures during
2008 allowed us to identify the classification of a number of commercial loans
earlier in the process during 2008, which contributed to the increase in
classified assets from 2007 to 2008.  In addition to our increased
focus on credit administration, deteriorating economic conditions in the markets
where were do business also contributed to the increase in classified
assets.




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, 2008, our allowance for loan losses was $1.3 million, or 0.50%, of
our total loan portfolio.  Our allowance in 2008 was higher than in
2007 and 2006, because of higher net charge-offs and recoveries, an increase to
the overall portfolio and a significant decline in the economic
environment.  In addition, the mix of our portfolio now includes more
real estate secured loans, which provides us with stronger collateral and
results in a reduction in our overall portfolio risk.


17




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 4 of the Notes to Consolidated Financial
Statements.




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





December
      31,2008
              
              
              2007
              
              
              2006
              
              
              2005
              
              
              2004(Dollars
      in thousands)Balance
      at beginning of period
              
              $
              828
              
              
              $
              822
              
              
              $
              1,321
              
              
              $
              1,033
              
              
              $
              826Charge-offs:One-to
      four-family
              
              
              114
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Home
      equity
              
              
              62
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Commercial
      real estate
              
              
              37
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Commercial
      business
              
              
              71
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Consumer
              
              
              507
              
              
              
              483
              
              
              
              1,013
              
              
              
              752
              
              
              
              741Recoveries:One-to
      four-family
              
              
              2
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Commercial
      business
              
              
              15
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Consumer
              
              
              142
              
              
              
              239
              
              
              
              233
              
              
              
              94
              
              
              
              91Net
      charge-offs
              
              
              632
              
              
              
              244
              
              
              
              780
              
              
              
              658
              
              
              
              650Additions
      charged to operations
              
              
              1,110
              
              
              
              250
              
              
              
              281
              
              
              
              946
              
              
              
              857Balance
      at end of period
              
              $
              1,306
              
              
              $
              828
              
              
              $
              822
              
              
              $
              1,321
              
              
              $
              1,033Net
      charge-offs during the
                period
      as a percentage of average loans
                outstanding during the period
              
              
              0.26
              %
              
              
              0.11
              %
              
              
              0.40
              %
              
              
              0.37
              %
              
              
              0.45
              %Net
      charge-offs during the
                period
      as a percentage of average non-
                performing assets
              
              
              144.46
              %
              
              
              33.46
              %
              
              
              184.42
              %
              
              
              262.67
              %
              
              
              427.63
              %Allowance
      as a percentage of
                Non-performing
      loans
              
              
              104.31
              %
              
              
              198.22
              %
              
              
              281.51
              %
              
              
              294.21
              %
              
              
              1,986.54
              %Allowance
      as a percentage of total loans
                (end
      of
      period)
              
              
              0.50
              %
              
              
              0.37
              %
              
              
              0.40
              %
              
              
              0.69
              %
              
              
              0.65
              %







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 decline 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 0.50% as of December 31, 2008
compared to 0.37% as of December 31, 2007.




During June 2007, 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, 2004 through
2006.  Net charge-offs for the credit card portfolio totaled $509,000
in 2006, $495,000 in 2005 and $508,000 in 2004.


18


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




2008
              
              
              2007
              
              
              2006
              
              
              2005
              
              
              2004Amount
              
              
              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
              
              $
              321
              
              
              
              34.33
              %
              
              $
              145
              
              
              
              38.37
              %
              
              $
              100
              
              
              
              41.60
              %
              
              $
              90
              
              
              
              39.84
              %
              
              $
              85
              
              
              
              42.55
              %Home
      equity
              
              
              240
              
              
              
              20.61
              
              
              
              100
              
              
              
              20.53
              
              
              
              40
              
              
              
              18.99
              
              
              
              35
              
              
              
              14.86
              
              
              
              30
              
              
              
              15.01Commercial
      real estate
              
              
              153
              
              
              
              18.41
              
              
              
              170
              
              
              
              11.32
              
              
              
              170
              
              
              
              8.46
              
              
              
              165
              
              
              
              8.10
              
              
              
              100
              
              
              
              9.47Construction
      or development
              
              
              55
              
              
              
              4.62
              
              
              
              25
              
              
              
              3.90
              
              
              
              30
              
              
              
              4.57
              
              
              
              20
              
              
              
              4.05
              
              
              
              20
              
              
              
              3.25Consumer(1)
              
              
              379
              
              
              
              15.36
              
              
              
              298
              
              
              
              20.99
              
              
              
              407
              
              
              
              22.71
              
              
              
              931
              
              
              
              27.84
              
              
              
              748
              
              
              
              26.84Commercial
      business
              
              
              158
              
              
              
              6.67
              
              
              
              90
              
              
              
              4.89
              
              
              
              75
              
              
              
              3.67
              
              
              
              80
              
              
              
              5.82
              
              
              
              50
              
              
              
              2.89Total
              
              $
              1,306
              
              
              
              100.00
              %
              
              $
              828
              
              
              
              100.00
              %
              
              $
              822
              
              
              
              100.00
              %
              
              $
              1,321
              
              
              
              100.00
              %
              
              $
              1,033
              
              
              
              100.00
              %





___________________________________




(1)
            Because
      of the sale of our credit card portfolio in June 2007, no portion of our
      allowance at December 31, 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 and 2004 was $600,000 and
      $518,000 respectively.





19


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 basic 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.”




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.




As a
member of the Federal Home Loan Bank of Seattle, we had $2.4 million in stock of
the Federal Home Loan Bank of Seattle at December 31, 2008. For the year ended
December 31, 2008, we received $13,000 in dividends from the Federal Home
Loan Bank of Seattle.


20


The
following table sets forth the composition of our securities portfolio and other
investments at the dates indicated.  At December 31, 2008, 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
      31,2008
                
                
                2007
                
                
                2006
                
                
                2005Amortized
                  Cost
                
                
                Fair
                  Value
                
                
                Amortized
                  Cost
                
                
                Fair
                  Value
                
                
                Amortized
                  Cost
                
                
                Fair
                  Value
                
                
                Amortized
                  Cost
                
                
                Fair
                  Value(In
      thousands)Securities
      available for sale, at fair value:Federal
      agency mortgage-backed
                
                $
                2,007
                
                
                $
                2,029
                
                
                $
                68
                
                
                $
                71
                
                
                $
                165
                
                
                $
                170
                
                
                $
                242
                
                
                $
                222Non-agency
      mortgage-backed (1)
                
                
                8,124
                
                
                
                6,901
                
                
                
                ---
                
                
                
                ---
                
                
                
                ---
                
                
                
                ---
                
                
                
                ---
                
                
                
                ---Total
      available for sale
                
                
                10,131
                
                
                
                8,930
                
                
                
                68
                
                
                
                71
                
                
                
                165
                
                
                
                170
                
                
                
                242
                
                
                
                222Federal
      Home Loan Bank stock
                
                
                2,444
                
                
                
                2,444
                
                
                
                1,320
                
                
                
                1,320
                
                
                
                1,320
                
                
                
                1,320
                
                
                
                1,320
                
                
                
                1,320Total
      securities
                
                $
                12,575
                
                
                $
                11,374
                
                
                $
                1,388
                
                
                $
                1,391
                
                
                $
                1,485
                
                
                $
                1,490
                
                
                $
                1,562
                
                
                $
                1,542


_________________


(1)
The non-agency mortgage backed securities have an unrealized loss of $1.2
million as of December 31, 2008.  These securities were purchased at a
discount between February and May 2008.  Each of these securities has
performed and paid principal and interest each month as contractually
committed.






21






The
composition and maturities of our investment securities portfolio at December
31, 2008, excluding Federal Home Loan Bank stock, are indicated in the following
table.





1
      year or less
              
              
              Over
      1 year
              
              
              Total
      SecuritiesAmortized
                  Cost
              
              
              Weighted
                  Average
                  Yield
              
              
              Amortized
                  Cost
              
              
              Weighted
                  Average
                  Yield
              
              
              Amortized
                  Cost
              
              
              Weighted
                  Average
                  Yield
              
              
              Fair
                  ValueDecember
      31, 2008Securities
      available for sale, at fair value:Federal
      agency mortgage-backedmor
              
              
              ---
              
              
              
              ---
              
              
              $
              2,007
              
              
              
              4.11
              %
              
              $
              2,007
              
              
              
              4.11
              %
              
              $
              2,028Non-Agency
      mortgage-backed
              
              
              ---
              
              
              
              ---
              
              
              $
              8,124
              
              
              
              7.14
              %
              
              $
              8,124
              
              
              
              7.14
              %
              
              $
              6,901Total
              
              
              ---
              
              
              
              ---
              
              
              $
              10,131
              
              
              
              6.59
              %
              
              $
              10,131
              
              
              
              6.59
              %
              
              $
              8,929December
      31, 2007Securities
      available for sale, at fair value:Federal
      agency mortgage-backed
              
              
              ---
              
              
              
              ---
              
              
              $
              68
              
              
              
              8.00
              %
              
              $
              68
              
              
              
              8.00
              %
              
              $
              71


22





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, 2008, approximately 5.4% of our deposits were from persons
outside the State of Washington.As of December 31, 2008,
core deposits, which we define as our non-certificate or non-time deposit
accounts, represented approximately 44% of total deposits, compared to 47% as of
December 31 2007.  We primarily rely on competitive pricing policies,
marketing and customer service to attract and retain these deposit and we expect
to continue these practices in the future.




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 try to 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 31,2008
                    
                    
                    2007
                    
                    
                    2006(Dollars
      in thousand)Opening
      balance
                    
                    $
                    202,791
                    
                    
                    $
                    180,968
                    
                    
                    $
                    168,173Net
      deposits (withdrawals)
                    
                    
                    11,329
                    
                    
                    
                    15,245
                    
                    
                    
                    7,354Interest
      credited
                    
                    
                    6,440
                    
                    
                    
                    6,578
                    
                    
                    
                    5,441Ending
      balance
                    
                    $
                    222,560
                    
                    
                    $
                    202,791
                    
                    
                    $
                    180,968Net
      increase
                    
                    $
                    19,769
                    
                    
                    $
                    21,823
                    
                    
                    $
                    12,795Percent
      increase
                    
                    
                    9.75
                    %
                    
                    
                    12.06
                    %
                    
                    
                    7.61
                    %













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
      31,2008
              
              
              2007
              
              
              2006Amount
              
              
              Percent
                of
      total
              
              
              Amount
              
              
              Percent
                of
      total
              
              
              Amount
              
              
              Percent
                of
      total(Dollars
      in thousand)Transactions
      and Savings Deposits:Interest-bearing
      demand
              
              $
              20,637
              
              
              
              9.30
              %
              
              $
              31,999
              
              
              
              15.78
              %
              
              $
              12,711
              
              
              
              7.02
              %Non
      interest-bearing checking
              
              
              12,589
              
              
              
              5.67
              
              
              
              13,290
              
              
              
              6.55
              
              
              
              17,251
              
              
              
              9.53Statement
      savings
              
              
              13,109
              
              
              
              5.64
              
              
              
              11,696
              
              
              
              5.77
              
              
              
              12,510
              
              
              
              6.91Money
      market
              
              
              51,744
              
              
              
              23.31
              
              
              
              39,754
              
              
              
              19.60
              
              
              
              53,270
              
              
              
              29.44Total
      non-certificates
              
              
              98,079
              
              
              
              43.92
              
              
              
              96,739
              
              
              
              47.70
              
              
              
              95,742
              
              
              
              52.91Certificates:1.00
      - 3.99%
              
              
              40,969
              
              
              
              18.46
              
              
              
              6,339
              
              
              
              3.13
              
              
              
              16,519
              
              
              
              9.134.00
      - 5.99%
              
              
              83,507
              
              
              
              37.62
              
              
              
              99,708
              
              
              
              49.17
              
              
              
              68,549
              
              
              
              37.876.00
      - 7.99%
              
              
              5
              
              
              
              0.00
              
              
              
              5
              
              
              
              0.00
              
              
              
              155
              
              
              
              0.098.00%
      and over
              
              
              ---
              
              
              
              ---
              
              
              
              ---
              
              
              
              ---
              
              
              
              3
              
              
              
              0.00Total
      certificates
              
              
              124,481
              
              
              
              56.08
              
              
              
              106,052
              
              
              
              52.30
              
              
              
              85,226
              
              
              
              47.08Total
      deposits
              
              $
              222,560
              
              
              
              100.00
              %
              
              $
              202,791
              
              
              
              100.00
              %
              
              $
              180,968
              
              
              
              100.00
              %








Recent increases in certificate
accounts reflect recent decreases in general market rates, which have made our
customers more willing to commit their funds for a specified time, as well as
the increase in FDIC insurance limits.  Money market accounts also
have increased and interest bearing demand deposits have decreased as a result
of changes to our pricing for those accounts. Our plans for 2009 are 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 have been approved as a public funds depository and as
of December 31, 2008, we have approximately $12.8 million in public
funds.





24


The
following table shows rate and maturity information for the Bank’s certificates
of deposit at December 31, 2008.








1.00-
                3.99%
              
              
              
              4.00-
                5.99%
              
              
              Total
              
              
              Percent
                of Total(Dollars
      in thousands)Certificate
      accounts
                maturing in quarter
      ending:March
      31,
      2009
              
              $
              7,947
              
              
              $
              8,073
              
              
              $
              16,020
              
              
              
              12.87
              %June
      30,
      2009
              
              
              8,438
              
              
              
              5,387
              
              
              
              13,825
              
              
              
              11.11September
      30, 2009
              
              
              2,322
              
              
              
              17,008
              
              
              
              19,330
              
              
              
              15.53December
      31, 2009
              
              
              17,846
              
              
              
              23,124
              
              
              
              40,970
              
              
              
              32.91March
      31,
      2010
              
              
              1,209
              
              
              
              5,008
              
              
              
              6,217
              
              
              
              4.99June
      30,
      2010
              
              
              1,107
              
              
              
              1,294
              
              
              
              2,401
              
              
              
              1.93September
      30, 2010
              
              
              96
              
              
              
              1,103
              
              
              
              1,199
              
              
              
              0.96December
      31, 2010
              
              
              1,304
              
              
              
              12,370
              
              
              
              13,674
              
              
              
              10.98March
      31,
      2011
              
              
              120
              
              
              
              4,368
              
              
              
              4,488
              
              
              
              3.61June
      30,
      2011
              
              
              272
              
              
              
              88
              
              
              
              360
              
              
              
              0.29September
      30, 2011
              
              
              143
              
              
              
              19
              
              
              
              162
              
              
              
              0.13December
      31, 2011
              
              
              1
              
              
              
              184
              
              
              
              185
              
              
              
              0.15Thereafter
              
              
              164
              
              
              
              5,486
              
              
              
              5,650
              
              
              
              4.54Total
              
              $
              40,969
              
              
              $
              83,512
              
              
              $
              124,481
              
              
              
              100.00
              %Percent
      of
      total
              
              
              32.9
              %
              
              
              67.1
              %
              
              
              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, 2008.





Maturity3
      months or less
              
              
              Over
      3 to 6 months
              
              
              Over
      6 to 12 months
              
              
              Over
      12 months
              
              
              Total(In
      thousands)Certificates
      of deposit less than $100,000
              
              $
              5,659
              
              
              $
              6,644
              
              
              $
              28,322
              
              
              $
              17,646
              
              
              $
              58,271Certificates
      of deposit of $100,000 or more
              
              
              10,361
              
              
              
              7,181
              
              
              
              31,978
              
              
              
              16,690
              
              
              
              66,210Total
      certificates of
      deposit
              
              $
              16,020
              
              
              $
              13,825
              
              
              $
              60,300
              
              
              $
              34,336
              
              
              $
              124,481







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 8 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 Bank’s 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 Bank has entered into a loan agreement with the
Federal Home Loan Bank of Seattle pursuant to which it


25




may
borrow up to approximately 20% of its assets, secured by a blanket pledge on a
portion of our residential mortgage portfolio.  At December 31, 2008,
we had $42.2 million in Federal Home Loan Bank advances outstanding, which had
maturities between zero and three years, and had the ability to borrow an
additional $30.6 million.  At the same date, we had $94.7 million in
residential mortgages, commercial real estate and mortgage-backed securities
available to serve as collateral for additional 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.  At December 31, 2008, we had
$2.4 million of FHLB Stock.




The Bank
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.  We have never
borrowed from the Federal Reserve Bank.





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





For
      the year ended December 31,2008
                  
                  
                  2007
                  
                  
                  2006(Dollars
      in thousands)Maximum
      balance:Federal
      Home Loan Bank advances
                  
                  $
                  56,119
                  
                  
                  $
                  34,519
                  
                  
                  $
                  24,485Average
      balances:Federal
      Home Loan Bank advances
                  
                  $
                  38,474
                  
                  
                  $
                  26,511
                  
                  
                  $
                  19,824Weighted
      average interest rate:Federal
      Home Loan Bank advances
                  
                  
                  3.31
                  %
                  
                  
                  5.08
                  %
                  
                  
                  4.77
                  %








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








December
      31,2008
                
                
                2007
                
                
                2006(Dollars
      in thousands)Federal
      Home Loan Bank advances
                
                $
                42,219
                
                
                $
                15,869
                
                
                $
                22,029Weighted average interest rate
      of:Federal
      Home Loan Bank advances
                
                
                2.73
                %
                
                
                4.63
                %
                
                
                4.84
                %





26


Subsidiary
and Other Activities




As a
federally chartered savings bank, we are permitted by OTS regulations to invest
up to 2% of our assets, or $5.9 million at December 31, 2008, in the stock of,
or unsecured loans to, service corporation subsidiaries.  We may
invest an additional 1% of our assets in service corporations where such
additional funds are used for inner-city or community development
purposes.  The Bank 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, 2008 was $2,000.




Competition




We face
strong competition in attracting deposits.  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 banking industry in Washington and other western
states.  These include such large national lenders as U.S Bank, JP
Morgan Chase, Wells Fargo, Bank of America, Citigroup 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 Bank’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
5.3%, with the five largest institutions in that county having 67.1% of the
deposits.




Employees




At
December 31, 2008, we had a total of 66 full-time employees and 15 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.


27




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.  The OTS issued a
supervisory directive to Sound Community Bank in November 2005, which addressed
the level of investment in commercial loans, asset classification and loan
review and improving earnings and capital levels.  Under that
directive, as amended, Sound Community Bank’s total investment in commercial
loans was limited to 15% of assets, of which at least initially 12% and later
10% had to be secured by commercial real estate.  Sound Community Bank
also was required to reach earnings and capital levels in their business plan
and enhance their loan review and classification process.  The
directive was terminated in August 2007.




Recent
Legislative and Regulatory Initiatives to Address Financial and Economic
Crises




The
Congress, Treasury Department and the federal banking regulators, including the
FDIC, have taken broad action since early September to address volatility in the
U.S. banking system.




The
Emergency Economic Stabilization Act of 2008 (“EESA”) authorizes the Treasury
Department to purchase from financial institutions and their holding companies
up to $700 billion in mortgage loans, mortgage-related securities and certain
other financial instruments, including debt and equity securities issued by
financial institutions and their holding companies in a troubled asset relief
program (”TARP”).  The purpose of TARP is to restore confidence and
stability to the U.S. banking system and to encourage financial institutions to
increase their lending to customers and to each other.  The Treasury
Department has allocated $250 billion towards the TARP Capital Purchase Program
(“CPP”).  Under the CPP, Treasury will purchase debt or equity
securities from participating institutions.  The TARP also will
include direct purchases or guarantees of troubled asset of financial
institutions.  Participants in the CPP are subject to executive
compensation limits and are encouraged to expand their lending and mortgage loan
modifications.




EESA also
increased FDIC deposit insurance on most accounts from $100,000 to
$250,000.  This increase is in place until the end of 2009 and is not
covered by deposit insurance premiums paid by the banking industry.




Following
a systemic risk determination, the FDIC established its Temporary Liquidity
Guarantee Program (TGLP) in October, 2008. Under the interim rule for the TGLP,
there are two parts to the program; the Debit Guarantee Program (DGP) and
Transaction Account Guarantee Program (TAGP). Eligible entities continue to
participate unless they opted out on or before December 5, 2008.




For the
DGP, eligible entities are generally US bank holding companies, saving and loan
holding companies, and FDIC-insured institutions.  Under the DGP, the
FDIC guarantees new senior unsecured debit of an eligible entity issued not
later than June 30, 2009, and, if and application is approved, guarantees
certain mandatory convertible debt.  The Bank opted out of the
DGP.




28






For the
TAGP eligible entities are FDIC-insured institutions. Under the TAGP, the FDIC
provides unlimited deposit insurance coverage through December 31, 2009 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.  NOW accounts and money market
deposit accounts are not covered.  Participating institutions pay fees
of 10 basis points (annualized) on the balance of each covered account in excess
of $250,000 during the period through December 31, 2009.  The Bank
participates in the TAGP. As of December 31, 2008, the Bank had $481,000 in
balances over $250,000 in such accounts.




Sound
Community Bank




The Bank,
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 Bank is intended for the protection of depositors and the
insurance of accounts fund and not for the purpose of protecting
shareholders.  The Bank 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
Bank also is subject to regulation and examination by the FDIC, which insures
the deposits of the Bank to the maximum extent permitted by law.




Office of Thrift
Supervision.  The investment and lending authority of the Bank
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 Bank is required to meet a qualified thrift lender
test.  This test requires the Bank 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, 2008, the Bank
met this requirement with a qualified thrift lender percentage of
68.35%.




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 Bank is regulated by the
OTS.  The Bank is generally authorized to branch
nationwide.




The Bank
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, 2008, the Bank’s lending limit
under this restriction was $3.9 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 Bank to provide for higher general
or specific loan loss reserves, which can impact our capital and
earnings.  As a federal savings bank, the Bank is subject to a
semi-annual assessment, based upon its total assets, to fund the operations of
the OTS.






29






Transactions
between the Bank 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 Bank’s capital.  In addition, the Bank 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 Bank.




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 Bank’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, 2008 were $147,000.  Those premiums will increase in 2009
due to recent strains on the FDIC deposit insurance fund due to the cost of
large bank failures and increase in the number of troubled banks.




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 Bank and may terminate our deposit insurance if
it determines that we have engaged in unsafe or unsound practices or is in an
unsafe or unsound condition.




In February 2009, the FDIC issued new
deposit premium regulations proving for increases or premiums, higher premiums
for institutions with secured debt (including FHLB advances and brokered
deposits) and a special assessment in the second quarter of 2009 to replenish
the fund.  Under these new deposit insurance premium regulations, the
FDIC assesses deposit insurance premiums on all FDIC-insured institutions
quarterly based on annualized rates for four risk categories.  Each
institution is assigned to one of four risk categories based on 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 DIF.  Under FDIC’s risk-adjustments range from 12
to 16 basis points for Risk Category I, and are 22 basis points for 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 rate after adjustments range from 7 to 24 basis points for Risk
Category I, 17 to 34 basis points Risk Category II, 27 to 58 basis points for
Risk Category III, and 40 to 77.5 basis points for Risk Category IV. The rule
also includes authority for the FDIC to increase or decrease total base
assessment rates in the future by as much as three basis points without a formal
rulemaking proceeding.




In
addition to the regular quarterly assessments, due to losses and projected
losses attributed to failed institutions, the FDIC has adopted a rule imposing
on every insured institution a special assessment equal to 20 basis points of
its assessment base as of June 30, 2009 to be collected on September 30, 2009.
The FDIC has indicated that if, its borrowing authority from the United States
Treasury is increased, it would reduce the special assessment to 10 basis
points. There is legislation pending to increase that borrowing authority from
$30 billion to $100 billion (and up to $500 billion under special
circumstances).




30




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 Bank are
subject to regulatory limits and requirement for transactions with
affiliates.




If the
Bank 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




Capital
Requirements for the Bank.  The Bank 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, 2008, the Bank had
tangible capital of $24.4 million or 8.29% of adjusted total assets. The capital
standards require core or Tier 1 capital equal to at least 3.0% of adjusted
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, 2008, the Bank had core capital equal to $24.4
million or 8.29% of adjusted total assets. The OTS also requires the Bank 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 Bank, at December 31, 2008, consisted of $1.3 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,
2008, the Bank had $207.1 million of risk-weighted assets and total capital of
$25.7 million or 12.4% 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






31






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 Bank 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 “well-capitalized”
institution if it has at least a 5.0% leverage capital ratio, a 6.0% Tier 1
risked-based capital ratio and an 10.0% total risk-based capital
ratio.  At December 31, 2008, the Bank 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
Bank may have a substantial adverse effect on its operations and
profitability.




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 Bank, including providing additional
capital to the Bank when it does not meet its capital
requirements.  As a result of this expectation, the OTS regulates the
ability of the Bank 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 Bank to make distributions of capital, which include
dividends, stock redemptions or repurchases, cash-out mergers and other
transactions charged to the capital account.  The Bank must file a
notice or application with the OTS before making any capital
distribution.  The Bank 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 Bank, 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 Bank.  In addition, the
Bank 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.






32








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
Bank.  The Company and the Bank’s federal income tax returns have
never been audited.




The
Company adopted the provisions of FASB Interpretation No. 48, 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, 2007 and at December 31,
2008.




The
Company recognizes interest accrued and penalties related to unrecognized tax
benefits in tax expense.  During the years ended December 31, 2008 and 2007
the Company recognized no interest and penalties.




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 Bank
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, 2008, 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 Bank.  Therefore any dividends it
receives from the Bank 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.






33








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




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, 2008.  All
of our offices are leased.  The operating leases contain renewal
options and require the Bank to pay property taxes and operating expenses on the
properties.  Our total rental expense for each of the years ended
December 31, 2008, 2007 and 2006 was $627,000, $538,000 and $582,000,
respectively. The aggregate net book value of the Company’s leasehold
improvements, furniture and equipment was $1.5 million at December 31, 2008. See
also Note 6 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.  However, we anticipate opening another
banking office in Clallam County, most likely in Port Angeles, during the second
quarter of 2009. We may open additional banking offices after 2008 to better
serve current customers and to attract new customers.


34







Location
            Year opened
            Owned
      orleased
            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
            20094Sequim
      Branch
              541
      North 5th
      Avenue
              Sequim,
      WA 98382
            1997
            Leased
            20135


_________________


1. Lease
contains no renewal option.


2. Lease
provides for four five-year renewals.


3. Lease
provides for one two-year renewal.


4. Lease
provides for one five-year renewal.


5. Lease
provides for two nine-year renewals.




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.    Submission of Matters to a Vote of Security
Holders




On
October 10, 2008, the Company held a Special Meeting of Shareholders at which
shareholders were asked to approve the Sound Financial, Inc. 2008 Equity
Incentive Plan.  This plan had to be approved by a majority of the
total votes eligible to be cast by shareholders and, in accordance with OTS
Regulations, by a majority of the total votes cast by shareholders other than
Sound Community MHC.




The
following is a record of the number of votes cast at the October 10, 2008
Special Meeting of Shareholders for the proposal to approve the Sound Financial,
Inc. 2008 Equity Incentive Plan:


35




For
                        Against
                        AbstainVotes
      by all Shareholders
                        2,404,248
                        201,710
                        21,281Votes
      by non-MHC Shareholders
                        782,813
                        201,710
                        21,281





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 2008.  We had no common stock
outstanding as of December 31, 2007. 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.




Stock
      Price
                    
                    Dividends
      per share2008
      Quarter
                    High
                    LowFirst
      Quarter (1/8/2008 to 3/31/2008)
                    $
      9.47
                    $
      9.00
                    
                    ---Second
      Quarter (4/1/2008 to 6/30/2008)
                    $
      9.24
                    $
      9.10
                    
                    $         0.04Third
      Quarter (7/31/2008 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, 2008, there were 2,948,063 shares outstanding and the closing price
of our common stock on that date was $7.12.  On that date, we had
approximately 320 shareholders of record.




Our cash
dividend payout policy is continually reviewed 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.




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


36




The
shareholders of Sound Financial, Inc. approved an equity compensation plan,
however we had not issue any shares of our Common Stock as of December 31,
2008.




On
November 24, 2008, the Company announced that its Board of Directors has
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.  No shares were repurchased under the plan during the
fourth quarter of 2008.


37




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 31,2008
              
              
              2007
              
              
              2006(In
      thousands)Selected Financial
      Condition Data:Total
      assets
              
              $
              293,497
              
              
              $
              236,965
              
              
              $
              220,663Loans
      receivable, net
              
              
              262,407
              
              
              
              219,406
              
              
              
              204,812Loans
      held for sale
              
              
              956
              
              
              
              822
              
              
              
              1,307Mortgage-backed
      securities available for sale (at fair value)
              
              
              8,930
              
              
              
              71
              
              
              
              170Federal
      Home Loan Bank stock
              
              
              2,444
              
              
              
              1,320
              
              
              
              1,320Deposits
              
              
              222,560
              
              
              
              202,791
              
              
              
              180,968Federal
      Home Loan Bank advances
              
              
              42,419
              
              
              
              15,869
              
              
              
              22,029Equity
              
              
              26,103
              
              
              
              15,888
              
              
              
              15,569







For
      the year ended
                  December
      31,2008
              
              
              2007
              
              
              2006(In
      thousands)Selected Operations
      Data:Total
      interest income
              
              $
              16,959
              
              
              $
              14,959
              
              
              $
              13,641Total
      interest expense
              
              
              7,713
              
              
              
              7,925
              
              
              
              6,386Net interest
      income
              
              
              9,246
              
              
              
              7,034
              
              
              
              7,255Provision
      for loan losses
              
              
              1,110
              
              
              
              250
              
              
              
              282Net interest income after
      provision for loan losses
              
              
              8,136
              
              
              
              6,784
              
              
              
              6,973Fees
      and service charges
              
              
              1,813
              
              
              
              1,633
              
              
              
              1,911Gain
      (loss) on sales of loans(1)
              
              
              (15
              )
              
              
              11
              
              
              
              2,277Gain
      (loss) on sales of securities
              
              
              154
              
              
              
              ---
              
              
              
              ---Other
      non-interest income
              
              
              223
              
              
              
              472
              
              
              
              424Total non-interest
      income
              
              
              2,175
              
              
              
              2,116
              
              
              
              4,612Total
      non-interest expense
              
              
              10,004
              
              
              
              8,519
              
              
              
              8,234Income
      before provision for income taxes
              
              
              307
              
              
              
              381
              
              
              
              3,351Provision
      for income taxes
              
              
              45
              
              
              
              62
              
              
              
              1,108Net income
              
              $
              262
              
              
              $
              319
              
              
              $
              2,243


_____________________________




(1)
            The
      gain on sale of loans for the year ended December 31, 2006 includes the
      $2.3 million gain on the sale of our $11.6 million credit card
      portfolio.


38







For
      the year ended
                              December 31,2008
                            
                            
                            2007
                            
                            
                            2006Selected Financial
      Ratios and Other Data:Performance
      ratios:(1)Return on assets (ratio of net
      income to average total assets)
                            
                            
                            0.10
                            %
                            
                            
                            0.14
                            %
                            
                            
                            1.06
                            %Return on equity (ratio of net
      income to average equity)
                            
                            
                            0.98
                            %
                            
                            
                            2.00
                            %
                            
                            
                            15.10
                            %Interest rate spread
      information:Average during
    period
                            
                            
                            3.50
                            %
                            
                            
                            3.11
                            %
                            
                            
                            3.53
                            %End of period
                            
                            
                            3.54
                            %
                            
                            
                            3.19
                            %
                            
                            
                            3.02
                            %Net interest margin(2)
                            
                            
                            3.64
                            %
                            
                            
                            3.22
                            %
                            
                            
                            3.64
                            %Non-interest income to operating
      revenue
                            
                            
                            19.04
                            %
                            
                            
                            23.12
                            %
                            
                            
                            39.81
                            %Operating expense to average
      total assets
                            
                            
                            3.69
                            %
                            
                            
                            3.70
                            %
                            
                            
                            3.90
                            %Average interest-earning assets
      to average interest-bearing liabilities
                            
                            
                            106.33
                            %
                            
                            
                            99.79
                            %
                            
                            
                            103.34
                            %Efficiency ratio(3)
                            
                            
                            87.59
                            %
                            
                            
                            93.10
                            %
                            
                            
                            69.39
                            %Asset quality
      ratios:Non-performing assets to total
      assets at end of period
                            
                            
                            1.01
                            %
                            
                            
                            0.54
                            %
                            
                            
                            0.18
                            %Non-performing loans to gross
      loans
                            
                            
                            0.47
                            %
                            
                            
                            0.19
                            %
                            
                            
                            0.14
                            %Allowance for loan losses to
      non-performing loans
                            
                            
                            104.31
                            %
                            
                            
                            198.22
                            %
                            
                            
                            281.51
                            %Allowance for loan losses to
      gross loans
                            
                            
                            0.49
                            %
                            
                            
                            0.37
                            %
                            
                            
                            0.40
                            %Net charge-offs to average loans
      outstanding
                            
                            
                            0.26
                            %
                            
                            
                            0.11
                            %
                            
                            
                            0.40
                            %Capital
      ratios:Equity to total assets at end of
      period
                            
                            
                            8.89
                            %
                            
                            
                            6.70
                            %
                            
                            
                            7.06
                            %Average equity to average
      assets
                            
                            
                            9.86
                            %
                            
                            
                            6.94
                            %
                            
                            
                            7.03
                            %Other
    data:Number of full service
      offices
                            
                            
                            5
                            
                            
                            
                            5
                            
                            
                            
                            5


__________________________________________




(1)
              Performance
      ratios during the 2006 periods include a $2.3 million gain resulting from
      the sale of our credit card portfolio in June 2006.(2)
              Net
      interest income divided by average interest earning
  assets.(3)
              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.









39






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
Bank, which converted from a state-charted credit union to a federally chartered
savings bank in 2003. Prior to that conversion, the Bank operated as Credit
Union of the Pacific.




In
connection with its organization, Sound Financial sold 1,297,148 shares of
common stock to investors at $10.00 per share in a subscription offering, which
closed on January 8, 2008.  Those shares constitute 44% of the
outstanding shares of common stock of Sound Financial.  In connection
with the closing of the offering, 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
Financial raised $12,971,480 in its public offering and after paying $1,005,000
in offering expenses, it contributed $8,000,000 to the Bank, lent $1,155,600 to
fund its employee stock ownership plan’s purchase of shares in the offering and
retained the remaining $2,792,000 for working capital.  The MHC
reorganization and stock offering were completed on January 8, 2008;
accordingly, the information in this document prior to that date relates solely
to the Bank.




The
Bank’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 $57.7 million and $39.6 million in
one- to four-family residential mortgage loans during the years ended December
31, 2008 and 2007, respectively.  During these same periods, we sold
$31.6 million and $25.6 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.


40




The
Bank’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 Bank’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.





Difficult
market conditions and economic trends have adversely affected our industry and
our business.




The Bank
is significantly affected by prevailing economic conditions as well as
government policies and regulations concerning, among other things, monetary and
fiscal affairs, housing and financial institutions.  Deposit flows are
influenced by a number of factors, including interest rates paid on competing
time deposits, other investments, account maturities, and the overall level of
personal income and savings.  Lending activities are influenced by the
demand for funds, the number and quality of lenders, and regional economic
cycles.  Sources of funds for lending activities of the Bank include
primarily deposits, borrowings, payments on loans and income provided from
operations.




Dramatic
declines in the housing market, with decreasing home prices and increasing
delinquencies and foreclosures, have negatively impacted the credit performance
of mortgage and construction loans and resulted in significant write-downs of
assets by many financial institutions.  General downward economic
trends, reduced availability of commercial credit and increasing unemployment
have negatively impacted the credit performance of commercial and consumer
credit, resulting in additional write-downs for many financial
institutions.  Concerns over the stability of the financial markets
and the economy also have resulted in decreased lending by many financial
institutions to their customers and to each other.  This market
turmoil and tightening of credit has led to increased delinquencies, lack of
customer confidence, increased market volatility and widespread reduction in
general business activity.  Some financial institutions have
experienced decreased access to deposits or borrowings.  The resulting
economic pressure on consumers and businesses and the lack of confidence in the
financial markets may adversely affect our business, results of operations and
stock price.




Our
ability to assess the creditworthiness of customers and to estimate the losses
inherent in our credit exposure is made more difficult and complex under these
difficult market and economic conditions.  We also expect to face
increased regulation and government oversight as a result of these downward
trends.  This increased government action may increase our costs and
limit our ability to pursue certain business opportunities.  We also
may be required to pay even higher FDIC premiums than the recently increased
level, because financial institution failures resulting from the depressed
market conditions have depleted and may continue to deplete the FDIC insurance
fund and reduce the FDIC’s ratio of reserves to insured deposits.




We do not
expect these difficult conditions to improve in the near future.  A
worsening of these conditions would likely exacerbate the adverse effects of
these difficult market and economic conditions on us, our customers and the
other financial institutions in our market.  As a result, we may
experience increases in foreclosures, delinquencies and customer bankruptcies,
as well as more restricted access to funds.





Recent
legislative and regulatory initiatives to address these difficult market and
economic conditions may not stabilize the U.S. banking system.




41


The recently
enacted Emergency Economic Stabilization Act of 2008 (“EESA”) authorizes the
U.S. Department of the Treasury (“Treasury Department”) to purchase from
financial institutions and their holding companies up to $700 billion in
mortgage loans, mortgage-related securities and certain other financial
instruments, including debt and equity securities issued by financial
institutions and their holding companies in a troubled asset relief program
(”TARP”).  The purpose of TARP is to restore confidence and stability
to the U.S. banking system and to encourage financial institutions to increase
their lending to customers and to each other.  The Treasury Department
has allocated $250 billion towards the TARP Capital Purchase Program
(“CPP”).  Under the CPP, Treasury will purchase debt or equity
securities from participating institutions.  The TARP also will
include direct purchases or guarantees of troubled asset of financial
institutions.  Our Board of Directors is currently evaluating whether
or not to participate in the CPP.





EESA also increased FDIC deposit
insurance on most accounts from $100,000 to $250,000.  This increase
is in place until the end of 2009 and is not covered by deposit insurance
premiums paid by the banking industry.  In addition, the FDIC has
implemented two temporary programs to provide deposit insurance for the full
amount of most non-interest bearing transaction accounts through the end of 2009
and to guarantee certain unsecured debt of financial institutions and their
holding companies through June 2012.  Financial institutions were
allowed to opt out of these two programs.  We opted out of the
guarantee of unsecured debt.  We are participating in the program that
provides unlimited deposit insurance coverage through December 31, 2009 for
noninterest-bearing transaction accounts (typically business checking accounts)
and certain funds swept into noninterest-bearing savings
accounts.  Under that program, we will pay a 10 basis points fee
(annualized) on the balance of each covered account in excess of $250,000, while
the extra deposit insurance is in place.  At December 31, 2008, we had
$386,000in such accounts in excess of
$250,000.





Our deposit insurance premiums during
the year ended December 31, 2008, were $147,000. Those premiums are expected to
increaseconsiderablyin 2009 due to recent strains on the
FDIC deposit insurance fund due to the cost of large bank failures and increase
in the number of troubled banks.  The current rates for FDIC
assessments have ranged from 5 to 43 basis points, depending on the health of
the insured institution.  The FDIC has increased the assessment range
to 12 to 50 basis points for the first quarter of 2009.  For the
remainder of 2009, it has proposed a range of 10 to 45 basis points for
institutions that do not trigger risk factors for brokered deposits and
unsecured debt and higher rates for those that do trigger those risk
factors.  The FDIC also proposed that it could increase assessment
rates in the future without formal rulemaking.





The purpose of these legislative and
regulatory actions is to stabilize the volatility in the U.S. banking
system.  EESA, TARP and the FDIC’s recent regulatory initiatives may
not have the desired effect.  If the volatility in the market and the
economy continue or worsen, our business, financial condition, results of
operations, access to funds and the price of our stock could be materially and
adversely impacted.





The recently enacted American Recovery
and Reinvestment Act of 2009 (the “ARRA”) is a broad based economic stimulus
bill that contains a broad range of tax revisions and government spending to
address the national economic decline.  It does not contain any
provisions specifically governing our operations.





Critical
Accounting Policies




Certain
of our accounting policies are important to the portrayal of our financial
condition, since they require management to make difficult, complex or
subjective judgments, some of 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 which could


42




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
mortgage servicing rights 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 this
prospectus.




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 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 collectibility of the loan
portfolio.  To strengthen our loan review and classification process,
which was part of an OTS supervisory directive that was terminated in August
2007, we engaged an independent consultant to review our classified commercial
loans and a sampling of our non-classified commercial loans.  We also
enhanced our credit administration policies and procedures to improve our
updated 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, our
regulators, as an integral part of their examination process, periodically
reviews our allowance for loan losses.  Such agencies 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.




Mortgage
Servicing Rights.We record mortgage servicing rights on loans
sold to Fannie Mae with servicing retained.  The Bank 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.  Our mortgage servicing rights
totaled $863,000 as of December 31, 2008.  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 which the Bank has taken control of in
partial or full satisfaction of loans. At the time of foreclosure, 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.


43







In some
instances, the Bank 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 SFAS No. 66,
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.  SFAS No. 109, “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 simply to provide innovative products and superior service to both
individuals and small businesses in our primary market areas, which we currently
provide through our five convenient full service banking centers located in the
heart of downtown Seattle, Lakewood, Mountlake Terrace, Sequim and Tukwila,
Washington.  We support these banking centers with 24/7 access to
on-line banking and participation in a world wide ATM network.  Our
basic operating strategy and goals are listed below.




Grow our
franchise and meet competition in our market through our excellent customer
service at our existing and new branch banking centers.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 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 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 expect
to expand our banking operations with a new banking office in each of 2009 and
2010.  Our next branch will be located in Port Angeles,
Washington.




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






44






withdrawal
when interest rates fluctuate. In order to build our core deposit base, we are
pursuing a number of strategies.  First, we continue to provide sales
promotions on savings and checking accounts to encourage the growth of these
types of deposits.  Second, 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.  Finally, we have made, and will continue to make, available
preferential loan and time deposit pricing to customers who maintain a
qualifying relationships at the 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, construction and development, 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.  Our
increased capital level resulting from the offering will enable us 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 work to improve asset
quality in recent years, through managing credit risk, however recent economic
conditions have contributed to an increase in nonperforming
assets.  However, our percentage of non-performing assets to total
assets increased to 1.01% at December 31, 2008 from 0.54% at December 31,
2007.  The increase in 2008 is the result of two foreclosed single
family residences, neither of which appears to pose the risk of a material loss
to the bank. 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 commercial
loans centrally to ensure uniformity and consistency in underwriting
decisions.




Leveraging our
capital.  We plan to improve our overall efficiency and
profitability by leveraging our increased capital base resulting from the
offering by increasing our borrowing capacity at the Federal Home Loan Bank of
Seattle.  We also will access alternative funding sources, including
lower cost deposits and loan sales.




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 2008, earnings were lower as
the result of lower than expected net interest income due to reductions in the
overall interest rate environment.  In addition, operating expenses
were higher than in 2007 as a result of additional staffing in our commercial
lending division.  Finally, our provision for loan losses was
significantly higher in 2008 than in 2007, reflecting the deterioration of the
economy both nationally and in the markets where we do business.




Comparison
of Financial Condition at December 31, 2008 and December 31, 2007




General.  Total assets
increased by $56.5 million, or 23.9%, to $293.5 million at December 31,
2008 from $237.0 million at December 31, 2007.  The increase was
primarily the result of a $43.6 million, or 19.7%, increase in our loan
portfolio, including loans held for sale, from $221.1 million at






45








December
31, 2007, to $264.7 million at December 31, 2008.  The increase also was the result of
an$8.4million increase in cash, cash
equivalents and securities
during2008.  This increase in total
assets was funded primarily
by the $10.9million
capital infusion from our stock offering, a $26.6million increase in net
FederalHome Loan Bank
advances and a $19.8million increase in deposits during 2008.




Loans.  Our
loan portfolio, including loans held for sale, increased $43.6 million, or
19.7%, from $221.1 million at December 31, 2007 to $264.7 million at December
31, 2008.  This increase in our loan portfolio consisted primarily of
a $21.4 million (78.3%) increase in commercial real estate loans, a $9.2 million
(20.2%) increase in home equity loans, a $11.3 million (14.3%) increase in
residential mortgage loans, including loans held for sale, and a $6.9 million
(63.6%) increase in commercial business loans, which was offset by a $5.7
million (12.3%) decrease in consumer loans.  The decrease in consumer
loans was a result of decreased demand for consumer based products such as autos
and boats as well as the Bank’s emphasis on limiting our exposure to borrowers
with below average credit score. The increases in our commercial real estate and
commercial business loan portfolios are consistent with our decision to increase
commercial lending (particularly commercial real estate lending).  The
increase in our residential loan portfolio is primarily the result of the lower
interest rate environment, which has led to an increase in refinance
transactions. Recently, housing inventories have increased resulting in a longer
marketing time and, therefore, fewer purchase transactions; however, prices in
the four-county area we serve have not deteriorated significantly. As a result
of the increase in residential loan originations, loans held for sale increased
$134,000, or 16.2%, from $822,000 at December 31, 2007, to $956,000 at December
31, 2008.




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 Statement of Financial Accounting Standards
(“SFAS”) No. 114.  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.




Our
allowance for loan losses at December 31, 2008 was $1.3 million or 0.49% of net
loans receivable, compared to $828,000 or 0.37% of net loans receivable at
December 31, 2007.  The increase in the allowance for loan losses was
due primarily to net charge-offs of non-performing loans of $632,000, offset by
a provision for loan losses of $1.1 million during the year ended December 31,
2008.  The increase to our provision was made as a result of increases
in our commercial and home equity loan portfolios and an evaluation of
prevailing housing and other market conditions and non-performing loans, a
slowdown in the local residential housing market and increases in our commercial
loan portfolios.  Non- performing
loans increased from $418,000 at December 31, 2007 to $1.3 million at December
31, 2008, primarily as a result of deteriorating market conditions in the areas
where were do business.  Specifically, housing prices in the Puget
Sound and Clallam County have declined substantially in 2008. Non-performing
loans to total loans increased from 0.19% at December 31, 2007 to 0.47% at
December 31, 2008.  Our loan portfolio includes a small quantity
of Alt-A, low-doc and stated income loans.  We






46








believe,
however, that our conservative underwriting policies and procedures have
resulted in good asset quality.  To date, we have not experienced any
significant delinquencies on these types of loans.




Cash and
Securities.  Cash and cash equivalents decreased by 497,000, or
8.1%, to $5.6 million at December 31, 2008.  Our securities portfolio
consists of mortgage-backed securities, all of which are designated as
available-for-sale.  The securities portfolio increased to $8.9
million at December 31, 2008 from $71,000 at December 31, 2007.  This
significant increase reflects our purchase of non-agency mortgage-backed
securities, which were purchased at a discount to face value with funds received
from our initial stock offering. These non-agency mortgage-backed securities
present a level of credit risk that does not exist currently with agency backed
securities which are guaranteed by the United States government. As of December
31, 2008, the unrealized loss on these non-agency mortgage backed securities was
approximately $1.2 million.  In order to monitor this risk, management
receives a credit surveillance report which 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.  Based on this
analysis, management does not expect to incur any principal loss on any of these
investments as of December 31, 2008.




Deposits.  Total
deposits increased by $19.8 million, or 9.8%, to $222.6 million at
December 31, 2008 from $202.8 million at December 31,
2007.  During 2008, time deposits increased $18.4 million and money
market accounts increased $12.0 million and savings accounts increased $826,000,
while demand deposits and interest-bearing checking accounts decreased $11.4
million.  Total demand deposits as of December 31, 2007 included $10.8
million deposited by investors in connection with our stock offering, which was
not closed until January 2008.  These funds were held in a checking
account and were subsequently used to purchase stock on the closing date. These
deposits artificially increased demand deposits as of December 31, 2007.
Exclusive of the deposits made by investors for the purchase of shares in Sound
Financial, Inc., demand deposits and interest-bearing checking accounts
decreased by $800,000. The increase in time deposits, savings and money market
accounts reflect a bank-wide emphasis to bring additional deposits to the
bank.




Borrowings.  Federal
Home Loan Bank advances increased $26.6 million, or 167.3%, to $42.4 million at
December 31, 2008 from $15.9 million at December 31, 2007.  These
additional advances were a combination of $15.0 million in long-term advances
and $12.0 million in overnight advances, net of repayments of an amortizing
advance totaling $600,000.  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, generally increases our overall cost of funds, however in the
current rate environment, the weighted average cost of new borrowings as of
December 31, 2008 was 1.66%, while our weighted average cost of deposits
was 3.04% at that date.




Equity.  Total
equity increased $10.2 million, or 64.3%, to $26.1 million at December 31, 2008
from $15.9 million at December 31, 2007, primarily as a result of the $10.8
million capital infusion from our stock offering (net of the related ESOP loan),
a reduction in other comprehensive gain (loss) of ($796,000), dividends paid of
$159,000 and net earnings of $262,000 in 2008.




47


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 31,2008
                    
                    
                    2007
                    
                    
                    2006Average
                      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)
                    
                    $
                    247,058
                    
                    
                    $
                    16,436
                    
                    
                    
                    6.65
                    %
                    
                    $
                    216,076
                    
                    
                    $
                    14,911
                    
                    
                    
                    6.90
                    %
                    
                    $
                    197,535
                    
                    
                    $
                    13,534
                    
                    
                    
                    6.85
                    %Mortgage-backed
      securities(2)
                    
                    
                    6,664
                    
                    
                    
                    510
                    
                    
                    
                    7.85
                    
                    
                    
                    118
                    
                    
                    
                    11
                    
                    
                    
                    9.32
                    
                    
                    
                    197
                    
                    
                    
                    (24
                    )
                    
                    
                    (12.16
                    )Other
                    
                    
                    1,796
                    
                    
                    
                    13
                    
                    
                    
                    0.74
                    
                    
                    
                    1,432
                    
                    
                    
                    37
                    
                    
                    
                    2.58
                    
                    
                    
                    1,579
                    
                    
                    
                    131
                    
                    
                    
                    8.29Total
      interest-earning assets(1)
                    
                    
                    255,518
                    
                    
                    
                    16,959
                    
                    
                    
                    6.64
                    
                    
                    
                    217,626
                    
                    
                    
                    14,959
                    
                    
                    
                    6.87
                    
                    
                    
                    199,311
                    
                    
                    
                    13,641
                    
                    
                    
                    6.84Interest-Bearing
      Liabilities:Savings
      and Money Markets
                    
                    
                    54,042
                    
                    
                    
                    1,100
                    
                    
                    
                    2.04
                    
                    
                    
                    56,512
                    
                    
                    
                    1,642
                    
                    
                    
                    2.91
                    
                    
                    
                    68,267
                    
                    
                    
                    2,077
                    
                    
                    
                    3.04Demand
      and NOW accounts
                    
                    
                    36,688
                    
                    
                    
                    294
                    
                    
                    
                    0.80
                    
                    
                    
                    32,727
                    
                    
                    
                    288
                    
                    
                    
                    0.88
                    
                    
                    
                    24,928
                    
                    
                    
                    29
                    
                    
                    
                    0.12Certificate
      accounts
                    
                    
                    111,741
                    
                    
                    
                    5,046
                    
                    
                    
                    4.52
                    
                    
                    
                    96,648
                    
                    
                    
                    4,649
                    
                    
                    
                    4.81
                    
                    
                    
                    79,747
                    
                    
                    
                    3,335
                    
                    
                    
                    4.18Borrowings
                    
                    
                    38,474
                    
                    
                    
                    1,273
                    
                    
                    
                    3.31
                    
                    
                    
                    26,511
                    
                    
                    
                    1,346
                    
                    
                    
                    5.08
                    
                    
                    
                    19,824
                    
                    
                    
                    945
                    
                    
                    
                    4.77Total
      interest-bearing liabilities
                    
                    
                    240,945
                    
                    
                    
                    7,713
                    
                    
                    
                    3.20
                    
                    
                    
                    212,398
                    
                    
                    
                    7,925
                    
                    
                    
                    3.73
                    
                    
                    
                    192,766
                    
                    
                    
                    6,386
                    
                    
                    
                    3.31Net
      interest income
                    
                    
                    
                    
                    
                    $
                    9,246
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    $
                    7,034
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    $
                    7,255Net
      interest rate spread
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    3.34
                    %
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    3.14
                    %
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    3.53
                    %Net
      earning assets
                    
                    $
                    14,573
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    $
                    5,228
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    $
                    6,545Net
      interest margin
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    3.62
                    %
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    3.23
                    %
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    3.64
                    %Average
      interest-earning assets to
                      average
      interest-bearing liabilities
                    
                    
                    
                    
                    
                    
                    106.05
                    %
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    102.46
                    %
                    
                    
                    
                    
                    
                    
                    103.40
                    %





______________________________________




(1)
              Calculated
      net of deferred loan fees, loan discounts, loans in process and loss
      reserves.(2)
              The
      negative yields during 2006 are the result of the acceleration of the
      amortization of premiums caused by significant prepayments during the
      periods.





48





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.








Year
      ended December 31,
                        2008 vs. 2007
                      
                      
                      Year
      ended December 31,
                        2007 vs. 2006Increase
                        (decrease)
      due to
                      
                      
                      Total
                        increase
                      
                      
                      Increase
                        (decrease)
      due to
                      
                      
                      Total
                        increaseVolume
                      
                      
                      Rate
                      
                      
                      (decrease)
                      
                      
                      Volume
                      
                      
                      Rate
                      
                      
                      (decrease)(In
      thousands)Interest-earning
      assets:Loans
      receivable
                      
                      $
                      1,593
                      
                      
                      $
                      (68
                      )
                      
                      $
                      1,525
                      
                      
                      $
                      1,274
                      
                      
                      $
                      103
                      
                      
                      $
                      1,377Mortgage-backed
      securities
                      
                      
                      520
                      
                      
                      
                      (21
                      )
                      
                      
                      499
                      
                      
                      
                      (5
                      )
                      
                      
                      40
                      
                      
                      
                      35Other
                      
                      
                      2
                      
                      
                      
                      (26
                      )
                      
                      
                      (24
                      )
                      
                      
                      (4
                      )
                      
                      
                      (90
                      )
                      
                      
                      (94
                      )Total interest-earning
      assets
                      
                      $
                      2,115
                      
                      
                      $
                      (115
                      )
                      
                      $
                      2,000
                      
                      
                      $
                      1,265
                      
                      
                      $
                      53
                      
                      
                      $
                      1,318Interest-bearing
      liabilities:Savings
      and Money Market
                      
                      $
                      (50
                      )
                      
                      $
                      (492
                      )
                      
                      $
                      (542
                      )
                      
                      $
                      (354
                      )
                      
                      $
                      (81
                      )
                      
                      $
                      (435
                      )Demand
      and NOW accounts
                      
                      
                      7
                      
                      
                      
                      (1
                      )
                      
                      
                      6
                      
                      
                      
                      40
                      
                      
                      
                      219
                      
                      
                      
                      259Certificate
      accounts
                      
                      
                      422
                      
                      
                      
                      (25
                      )
                      
                      
                      397
                      
                      
                      
                      758
                      
                      
                      
                      556
                      
                      
                      
                      1,314Borrowings
                      
                      
                      150
                      
                      
                      
                      (223
                      )
                      
                      
                      (73
                      )
                      
                      
                      329
                      
                      
                      
                      72
                      
                      
                      
                      401Total interest-bearing
      liabilities
                      
                      $
                      529
                      
                      
                      $
                      (741
                      )
                      
                      
                      (212
                      )
                      
                      $
                      774
                      
                      
                      $
                      765
                      
                      
                      
                      1,539Net
      interest income (loss)
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      $
                      2,212
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      $
                      (221
                      )








49


Comparison
of Results of Operation for the Year Ended December 31, 2008 and
2007




General.Net income decreased
$57,000to $262,000for the year ended December 31, 2008
compared to $319,000for the year ended December
31, 2007.  The primary reasons for this decrease were the
$860,000increase in the provision forloan losses and a $1.5million increase in
non-interest expense, including a $200,000 contribution to the Sound Community
Foundation, which were partially offset by a $2.2million increase in net interest income
and a $60,000increase in non-interest income compared
to the year ended December 31, 2007.




Interest
Income.The
increase was primarily the
result of theincreased volume of loans originated and
purchased in 2008, notwithstanding the decreasein the prime interest rate and the
1-year Treasury bill rate, which we use to set and adjust loan rates for certain
variable rate loans.  We anticipate our weighted average yield on
loans will improve as we continue to emphasize higher yielding commercial real
estate and business loans. However, this improvement will also depend on the
movement of the prime
interest rate and overall market rates




Interest income increased by
$2.0million, or13.4%, to $17.0million for the year ended December 31,
2008, from
$15.0million for the year
ended December 31, 2007.  The increase in interest income for the
period reflects the increased amount of loans and securities outstanding during
the 2008 period. The weighted average yield on loans decreased from6.90% for the year ended December 31, 2007,
to6.65% for the year ended December 31, 2008due to reductions in market
interest rates.




Interest
Expense.Interest expense decreased $211,000, or2.7%, to $7.7million for the year ended December 31,
2008, from $7.9million for the year ended December 31,
2007.




The decrease in interest expense for the
2008 period reflects lower interest rates paid on new and renewed certificates
of deposit in the current interest rate environment as well as decreased
borrowing costs on our Federal Home Loan Bank advances.  Our weighted
average cost of interest-bearing liabilities was3.20% for the year ended December 31, 2008,
compared to3.73% for the same period in
2007.




For the year ended December 31,
2008, interest paid on
deposits decreased by
$138,000, as compared to the year ended December
31, 2007in spite of a
$17.6 million dollar increase in average balances.The increase in balances was
offset by a lower weighted average cost of deposits for the year ended December
31, 2008 of3.17% compared to3.54% for the year ended December 31,
2007.




For the year ended December 31, 2008,
interest expense on Federal Home Loan Bank advances decreased $73,000, or5.4%, to $1,273,000from $1,346,000for the year ended December 31,
2007.  The decrease resulted from a lower cost of Federal Home Loan
Bank advances from a weighted average cost of3.31% for the year ended December 31, 2007,
to a weighted average cost of5.08% for the year ended December 31,
2008.In addition, the cost of Federal Home
Loan Bank advances
decreased 58basis points
from 2007 to 2008.




Net
Interest Income.Net interest income
increased $2.2million, or31.4%, to $9.2million for the year ended December 31,
2008, from $7.0million for the year ended December 31,
2007.  The increase in net interest income for the year ended December
31, 2008 primarily resulted from increased income from investments purchased in
2008, the increased volume
in loansand lower cost of
funds for the period. Our net interest margin was3.62% for the year ended December 31,
2008, compared to
3.24% for the year ended
December 31, 2007.


50




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 $1.1 millionwas made during the year ended December
31, 2008, compared to provision of $250,000during the year ended December 31,
2007.   The higher provision wasprimarily attributable to increases in
net charge-offs, increases in our commercial loan portfolio, an increase in our
overall loan portfolio and the overriding market conditions nationally and in
the areas where we do business.




At December 31, 2008, the
annualizedpercentageof
netcharge-offs to average
loans increased15basis points to0.26% from0.11% at December 31, 2007.  Thepercentageof non-performing loans to total loansincreased from0.19% at December 31, 2007 to0.47% at December 31, 2008.See Item 1 – Business –
Lending Activities -- Non-performing Assets in this Form
10-K.




Noninterest
Income.Noninterest income increased
$60,000, or2.8%, to $2.2 millionfor the year ended December 31, 2008,
from $2.1
millionfor the year ended
December 31, 2007.  The primary reason for this increase was an
increase in service charges and fee income of $180,000as a result of higher checking account
service charge revenue, a
$19,000 increase in mortgage servicing income and a $154,000 gain on the
mandatory redemption of our Class B shares in Visa, Inc (see below), which was partially offset by a
$296,000increase in the loss on sale of loans
and repossessed assets for the year ended December 31, 2008, compared to the
same period in 2007.




The $154,000gain on the sale on investments
resultedfrom the mandatory redemption of a
portion of our Class B Visa, Inc. shares as part of Visa's initial public
offering.  The Bank obtained its Visa shares, because it was a
long-time Visa member, prior to the sale of its credit card portfolio in2007.  We continue to own 5,699
shares of Visa Class B shares that are convertible into Class A
shares.  Each Class B share currently is convertible into 0.71429
Class A shares, which are traded on the New York Stock Exchange.  The
amount of Class A shares the Bank could realize upon conversion of its Class B
shares are expected to change as VISA issues additional Class A shares to fund
the escrow account to cover the remaining amount of the Discover
settlement.  The Class B shares carry a three-year lock-up provision
and may not be converted or redeemed during that period. If those shares could
be converted as of December 31, 2008, they would have a market value of
approximately $298,000




Noninterest
Expense.Noninterest expense
increased $1.5
million, or17.4%, to $10.0million for the year ended December 31,
2008, compared to $8.5million for the year ended December 31,
2007.  The increase in the 2008 period was primarily the result of an
increase in salaries and benefits of $903,000and operations expenses increasing
$903,000as the result of adding additional
staff to our commercial banking division and the hiring of our new Senior Vice
President - Retail Banking, as well as expense related to our employee stock ownershipplan.Operations expenses increased
$903,000, or38.6%, to $3.2 millionfor the year ended December 31, 2008,
from $2.3million for the year ended December
31,


51




2007.  The increase in
operations expensewas the
results ofhigher legal,
audit and printing fees resulting from being a public companyand the special meeting for the
approval of the 2008 Equity Incentive Plan.Also, the bank paid higher FDIC
insurance premiums in 2008 compared to 2007.These increases were offset by a
$341,000decrease in data
processing expenses resulting from streamlining certain data processing
functions.




The increase in the 2008 period was also
the result of our $200,000 charitable contribution to Sound Community Foundation
(a non-stock Washington corporation we founded in connection with our stock
offering).




Income
Tax Expense.  
For the year ended December 31, 2008, we incurred income tax expense of
$45,000on our pre-tax income as compared
to income tax expense of
$62,000for the year ended
December 31, 2007.The effective tax rates for December 31, 2008 and December 31, 2007 were 14.7%
and 16.3%, respectively





Liquidity




Liquidity
management is both a daily and long-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 Bank 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, 2008, the
Company had $14.5 million in cash and investment securities available for sale
and $956,000 in loans held for sale generally available for its cash
needs.  We can also generate funds from borrowings, primarily Federal
Home Loan Bank.  At December 31, 2008, the Bank had the ability to
borrow an additional $31.0 million in Federal Home Loan Bank
advances.




As of
December 31, 2008, our total borrowing capacity was $73.4 million with the
Federal Home Loan Bank of Seattle, subject to certain requirements, with unused
borrowing capacity of $31.0 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.




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, 2008, the approved outstanding loan commitments, including unused
lines of credit, amounted to $41.9 million.  Certificates of deposit
scheduled to mature in one year or less at December 31, 2008, totaled $90.3
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 Bank.




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.




52




In the normal course of operations, the
Bank 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, 2008, 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
commitments to extend credit at December 31, 2008, is as follows:




Off-balance sheet loan
      commitments:Commitments
      to make loans
                  
                  $
                  5,609Undisbursed
      portion of loans closed
                  
                  
                  1,811Unused
      lines of
      credit
                  
                  
                  32,129Irrevocable
      letters of
      credit
                  
                  
                  2,283Total
      loan
      commitments
                  
                  $
                  41,832




Capital




The Bank
is subject to minimum capital requirements imposed by the OTS.  Based
on its capital levels at December 31, 2008, the Bank exceeded these requirements
as of that date and continues to exceed them as of the date of this
prospectus.  Consistent with our goals to operate a sound and
profitable organization, our policy is for the Bank to maintain a
“well-capitalized” status under the capital categories of the
OTS.  Based on capital levels at December 31, 2008, the Bank was
considered to be well-capitalized.  Management monitors the capital
levels of the Bank to provide for current and future business opportunities and
to meet regulatory guidelines for “well-capitalized”
institutions.  The following table shows the capital ratios of the
Bank at December 31, 2008.




Actual
                  
                  
                  Minimum Capital
                    Requirements
                  
                  
                  Minimum Required to
                    Be Well-Capitalized
                    Under Prompt
                    Corrective
                    Action
      ProvisionsAmount
                  
                  
                  Ratio
                  
                  
                  Amount
                  
                  
                  Ratio
                  
                  
                  Amount
                  
                  
                  Rate(Dollars
      in thousands)Core capital (to total
      adjusted  assets)
                  
                  $
                  24,393
                  
                  
                  
                  8.31
                  %
                  
                  $
                  11,740
                  
                  
                  
                  4.00
                  %
                  
                  $
                  14,675
                  
                  
                  
                  5.00
                  %Core
      capital (to risk-weighted assets)
                  
                  $
                  24,393
                  
                  
                  
                  11.77
                  %
                  
                  $
                  8,285
                  
                  
                  
                  4.00
                  %(1)
                  
                  $
                  12,427
                  
                  
                  
                  6.00
                  %Risked-based capital (to risk-weighted assets)
                  
                  $
                  25,549
                  
                  
                  
                  12.40
                  %
                  
                  $
                  16,569
                  
                  
                  
                  8.00
                  %
                  
                  $
                  20,712
                  
                  
                  
                  10.00
                  %


__________________________________________




(1)
            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.”


53


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 good and
services normally purchased by the Bank.   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.




54




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 Bank
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 management
policy.  The board of directors sets the asset and liability policy
for the Bank, 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 Bank’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 Bank 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


55




determine
whether the Bank’s interest rate exposure is within the limits established by
the board of directors.




The
Bank’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, 2008, except in the case of a
200 basis point increase in rates.




The table
presented below, as of September 30, 2008 (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.




As
illustrated in the tables below, the Bank 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.




September
      30, 2008Change
      in
              Interest
              Rates
      in
            
            Net
      Portfolio Value
            
            NPVBasis
      Points
            
            $
      Amount
            
            $
      Change
            
            %
      Change
            
            Ratio
      %(Dollars
      in thousands)300bp
            
            $22,073
            
            $-6,635
            
            -23%
            
            8.28%200bp
            
            24,486
            
            -4,222
            
            -15%
            
            9.05%100bp
            
            26,653
            
            -2,055
            
            -7%
            
            9.71%0bp
            
            28,708
            
            
            
            
            
            10.31%(100)bp
            
            30,395
            
            1,687
            
            +6%
            
            10.78%




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 Bank’s level of
interest rate risk is acceptable under this approach.


56




In
evaluating the Bank’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 Bank
considers all of these factors in monitoring its exposure to interest rate
risk.


57




Item
8.  Financial Statements and Supplementary Data





REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM







To the
Board of Directors










We have
audited the accompanying consolidated balance sheets of Sound Financial, Inc and
Subsidiary (the Company) as of December 31, 2008 and 2007, and the related
consolidated statements of income, stockholders’ equity, comprehensive income,
and cash flows for the two years then ended. 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, 2008 and 2007, and the results
of their operations and their cash flows for the two years then ended, in
conformity with accounting principles generally accepted in the United States of
America.





/s/ Moss
Adams LLP





Everett,
Washington


March 30,
2009


58


SOUND
FINANCIAL, INC. AND SUBSIDIARY


Consolidated
Balance Sheets





DECEMBER
      31,
              
              
              DECEMBER
      31,2008
              
              
              2007ASSETSCash
      and cash equivalents
              
              $
              5,607,800
              
              
              $
              6,104,963Securities
      available-for-sale (AFS), at fair value
              
              
              8,929,798
              
              
              
              71,245Federal
      Home Loan Bank (FHLB) stock, at cost
              
              
              2,444,000
              
              
              
              1,319,500Loans
      held for sale
              
              
              955,595
              
              
              
              822,129Loans
              
              
              263,712,797
              
              
              
              220,233,447Less
      allowance for loan losses
              
              
              (1,305,950
              )
              
              
              (827,688
              )Total
      loans
              
              
              262,406,847
              
              
              
              219,405,759Accrued
      interest receivable
              
              
              1,219,645
              
              
              
              1,051,476Premises
      and equipment, net
              
              
              1,545,705
              
              
              
              1,404,853Bank-owned
      life insurance
              
              
              6,195,055
              
              
              
              4,035,412Mortgage
      servicing rights
              
              
              863,146
              
              
              
              864,946Other
      real estate owned
              
              
              1,250,531
              
              
              
              817,108Other
      assets
              
              
              2,079,177
              
              
              
              1,068,008Total
      assets
              
              $
              293,497,299
              
              
              $
              236,965,399


LIABILITIES


DepositsInterest-bearing
                      
                      $
                      209,583,218
                      
                      
                      $
                      189,501,253Noninterest-bearing
      demand
                      
                      
                      13,176,999
                      
                      
                      
                      13,289,946Total
      deposits
                      
                      
                      222,760,217
                      
                      
                      
                      202,791,199FHLB
      advances
                      
                      
                      42,219,355
                      
                      
                      
                      15,869,355Accrued
      interest payable
                      
                      
                      259,757
                      
                      
                      
                      210,518Other
      liabilities
                      
                      
                      1,825,143
                      
                      
                      
                      1,951,786Advance
      payments from borrowers for taxes and insurance
                      
                      
                      330,319
                      
                      
                      
                      254,213Total
      liabilities
                      
                      
                      267,394,791
                      
                      
                      
                      221,077,071COMMITMENTS ANDCONTINGENCIES (NOTE
      15)STOCKHOLDERS'
      EQUITYPreferred
      stock, $0.01 par value, 1,000,000 shares authorized, none
      issued
                      
                      
                      -
                      
                      
                      
                      -Common
      stock, $0.01 par value, 24,000,000 shares authorized, 2,948,063
                        shares issued and 2,844,059 outstanding as of December 31, 2008, no
                        shares issued and outstanding as of December 31, 2007
                      
                      
                      29,480
                      
                      
                      
                      -Additional
      paid-in capital
                      
                      
                      11,936,035Unearned
      shares - Employee Stock Ownership Plan (“ESOP”)
                      
                      
                      (1,057,997
                      )
                      
                      
                      -Retained
      earnings
                      
                      
                      15,987,547
                      
                      
                      
                      15,885,167Accumulated
      other comprehensive (loss) income, net of tax
                      
                      
                      (792,557
                      )
                      
                      
                      3,161Total
      stockholders’ equity
                      
                      
                      26,102,508
                      
                      
                      
                      15,888,328Total
      liabilities and stockholders’ equity
                      
                      $
                      293,497,299
                      
                      
                      $
                      236,965,399




See notes to consolidated financial
statements.


59


SOUND
FINANCIAL, INC. AND SUBSIDIARY


Consolidated
Statements of Income





YEARS
      ENDED DECEMBER 31,2008
              
              
              2007INTEREST
      INCOMELoans,
      including fees
              
              $
              16,435,721
              
              
              $
              14,910,648Interest
      and dividends on investments and cash equivalents
              
              
              522,933
              
              
              
              47,987Total
      interest income
              
              
              16,958,654
              
              
              
              14,958,635INTEREST
      EXPENSEDeposits
              
              
              6,440,185
              
              
              
              6,578,434FHLB
      advances
              
              
              1,273,281
              
              
              
              1,346,127Total
      interest expense
              
              
              7,713,466
              
              
              
              7,924,561NET
      INTEREST INCOME
              
              
              9,245,188
              
              
              
              7,034,074PROVISION
      FOR LOAN LOSSES
              
              
              1,110,000
              
              
              
              250,000NET
      INTEREST INCOME AFTER PROVISIONFOR
      LOAN LOSSES
              
              
              8,135,188
              
              
              
              6,784,074NONINTEREST
      INCOMEService
      charges and fee income
              
              
              1,813,343
              
              
              
              1,632,957Earnings
      on cash surrender value of bank ownedlife
      insurance
              
              
              159,643
              
              
              
              156,831Mortgage
      servicing income
              
              
              333,834
              
              
              
              314,765Gain
      on sale of securities
              
              
              153,633
              
              
              
              -Gain
      (loss) on sale of assets
              
              
              (285,135
              )
              
              
              10,949Total
      noninterest income
              
              
              2,175,318
              
              
              
              2,115,502NONINTEREST
      EXPENSESalaries
      and benefits
              
              
              4,991,553
              
              
              
              4,088,474Operations
              
              
              3,239,755
              
              
              
              2,389,294Occupancy
              
              
              1,004,751
              
              
              
              932,324Data
      processing
              
              
              767,777
              
              
              
              1,108,362Total
      noninterest expense
              
              
              10,003,836
              
              
              
              8,518,453INCOME
      BEFORE PROVISION FOR INCOME TAXES
              
              
              306,670
              
              
              
              381,122PROVISION
      FOR INCOME TAXES
              
              
              45,095
              
              
              
              61,986NET
      INCOME
              
              $
              261,575
              
              
              $
              319,136Earnings
      per common shareBasic
              
              $
              0.09
              
              
              
              N/ADiluted
              
              $
              0.09
              
              
              
              N/A




N/A - Earnings per common
share information is not applicable for the prior period.  The Company did
not complete their minority offering until January 8, 2008.





See notes to consolidated financial
statements


60


SOUND
FINANCIAL, INC. AND SUBSIDIARY


Consolidated
Statements of Stockholders’ Equity





Common
      StockShares
                      
                      
                      Amount
                      
                      
                      Additional
                        Paid-in
                        Capital
                      
                      
                      Unearned
                        Shares
      Issued
                        to
      ESOP
                      
                      
                      Retained
                        Earnings
                      
                      
                      Accumulated
                        Other
                        Comprehensive
                        Income
      (Loss)
                      
                      
                      Total
                        Stockholders'
                        Equity
                      
                      
                      Comprehensive
                        Income
                        (loss)BALANCE,
      December 31, 2006
                      
                      
                      
                      
                      $
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      $
                      15,566,031
                      
                      
                      $
                      3,044
                      
                      
                      $
                      15,569,075Net
      income
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      319,136
                      
                      
                      
                      
                      
                      
                      
                      319,136
                      
                      
                      
                      319,136Unrealized
      gain on available-for-salesecurities,
      net of tax
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      -
                      
                      
                      
                      117
                      
                      
                      
                      117
                      
                      
                      
                      117BALANCE,
      December 31, 2007
                      
                      
                      
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      15,885,167
                      
                      
                      $
                      3,161
                      
                      
                      $
                      15,888,328
                      
                      
                      $
                      319,253Net
      income
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      261,575
                      
                      
                      
                      
                      
                      
                      
                      261,575
                      
                      
                      
                      261,575Common
      Stock Issued
                      
                      
                      2,832,503
                      
                      
                      
                      29,480
                      
                      
                      
                      11,918,078
                      
                      
                      
                      (1,155,600
                      )
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      10,791,958ESOP
      Shares committed to be released
                      
                      
                      11,556
                      
                      
                      
                      
                      
                      
                      
                      17,957
                      
                      
                      
                      97,603
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      115,560Dividends
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      (159,195
                      )
                      
                      
                      
                      
                      
                      
                      (159,195
                      )Unrealized (loss) on available-
                          for-salesecurities, net
      of tax
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      (795,718
                      )
                      
                      
                      (795,718
                      )
                      
                      
                      (795,718
                      )BALANCE,
      December 31, 2008
                      
                      
                      2,844,059
                      
                      
                      $
                      29,480
                      
                      
                      $
                      11,936,035
                      
                      
                      $
                      (1,057,997
                      )
                      
                      $
                      15,987,547
                      
                      
                      $
                      (792,557
                      )
                      
                      $
                      26,102,508
                      
                      
                      $
                      (534,143
                      )





















































See
notes to consolidated financial statements.


61


SOUND
FINANCIAL, INC. AND SUBSIDIARY


Consolidated
Statements of Cash Flows


YEAR
      ENDEDDECEMBER
      31,2008
              
              
              2007CASH
      FLOWS FROM OPERATING ACTIVITIESNet
      income
              
              $
              261,575
              
              
              $
              319,136Adjustments
      to reconcile net income to net cash from operating
    activitiesAmortization
      of net (premium) discount on investments
              
              
              (90,047
              )
              
              
              3,544Provision
      for loan losses
              
              
              1,110,000
              
              
              
              250,000Depreciation
      and amortization
              
              
              404,382
              
              
              
              331,551Additions
      to mortgage servicing rights
              
              
              (339,808
              )
              
              
              (247,481
              )Amortization
      of mortgage servicing rights
              
              
              341,608
              
              
              
              250,097Increase
      in cash surrender value of bank owned life insurance
              
              
              (159,643
              )
              
              
              (156,831
              )Deferred
      income tax
              
              
              (286,000
              )
              
              
              (93,000
              )Proceeds
      from sale of loans
              
              
              31,552,290
              
              
              
              25,643,933Originations
      of loans held for sale
              
              
              (31,701,551
              )
              
              
              (22,728,821
              )Loss
      on sale of other real estate owned
              
              
              100,659
              
              
              
              -Loss
      on sale of repossessed assets
              
              
              168,681
              
              
              
              -(Gain)
      loss on sale of loans
              
              
              15,795
              
              
              
              (10,949
              )(Decrease)
      increase in operating assets and liabilitiesChange
      in accrued interest receivable
              
              
              (168,169
              )
              
              
              (156,094
              )Change
      in other assets
              
              
              94,961
              
              
              
              58,355Change
      in accrued interest payable
              
              
              49,239
              
              
              
              88,957Change
      in other liabilities
              
              
              (541,644
              )
              
              
              234,235Net
      cash from operating activities
              
              
              812,328
              
              
              
              3,786,632CASH
      FLOWS FROM INVESTING ACTIVITIESProceeds
      from maturities of AFS investments
              
              
              678,817
              
              
              
              94,897Purchase
      of AFS investments
              
              
              (10,648,170
              )
              
              
              -Purchase
      of bank owned life insurance
              
              
              (2,000,000
              )
              
              
              (600,000
              )Purchase
      of FHLB Stock
              
              
              (1,124,500
              )
              
              
              -Net
      increase in loans
              
              
              (47,912,610
              )
              
              
              (18,079,776
              )Improvements
      to OREO
              
              
              (159,966
              )
              
              
              -Proceeds
      from sale of OREO
              
              
              3,258,725
              
              
              
              -Purchases
      of premises and equipment
              
              
              (545,234
              )
              
              
              (406,205
              )Net
      cash from investing activities
              
              
              (58,452,938
              )
              
              
              (18,991,084
              )CASH
      FLOWS FROM FINANCING ACTIVITIESNet
      increase in deposits
              
              
              19,969,018
              
              
              
              21,823,205Proceeds
      from FHLB advances
              
              
              26,950,000Repayment
      of FHLB advances
              
              
              (600,000
              )
              
              
              (6,160,000
              )Net
      proceeds from stock issuance
              
              
              10,809,915
              
              
              
              -Cash
      dividends paid
              
              
              (159,195
              )
              
              
              -ESOP
      Shares released
              
              
              97,603
              
              
              
              -Net
      change in advances from borrowers for taxes and insurance
              
              
              76,106
              
              
              
              (3,096
              )Net
      cash from financing activities
              
              
              57,143,447
              
              
              
              15,660,109INCREASE
      (DECREASE) IN CASHAND
      CASH EQUIVALENTS
              
              
              (497,163
              )
              
              
              455,657CASH
      AND CASH EQUIVALENTS, beginning of period
              
              
              6,104,963
              
              
              
              5,649,306CASH
      AND CASH EQUIVALENTS, end of period
              
              $
              5,607,800
              
              
              $
              6,104,963SUPPLEMENTAL
      CASH FLOW INFORMATIONCash
      paid for income taxes
              
              $
              315,000
              
              
              $
              120,000Interest
      paid on deposits and FHLB advances
              
              $
              7,664,227
              
              
              $
              5,770,819Transfer
      to other real estate owned
              
              $
              3,632,841
              
              
              $
              817,108


See
notes to consolidated financial statements.


62


SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements





1.           ORGANIZATION
AND SIGNIFICANT ACCOUNTING POLICIES





Organization and principles of
consolidation - Sound Financial, Inc. (“Sound Financial” or the
“Company”) was incorporated under federal law on January 8, 2008, to hold all of
the stock of Sound Community Bank (sometimes referred to herein as the
“Bank”).  Sound Financial is a savings and loan holding company and is
subject to regulation by the Office of Thrift Supervision.  On an
unconsolidated basis, Sound Financial’s assets consist of all of the outstanding
shares of common stock of Sound Community Bank, $2.4 million in cash and a loan
to the Sound Financial employee stock ownership plan.  Sound Financial
has no significant liabilities.




Sound
Financial sold 1,297,148 shares of common stock to investors at $10.00 per share
in a subscription offering, which closed on January 8, 2008.  Those
shares constitute 44% of the outstanding shares of common stock of Sound
Financial.  In connection with the closing of the offering, 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
Financial raised $12,971,480 in its public offering and after paying $1,005,000
in offering expenses, it contributed $8,000,000 to the bank, lent $1,155,600 to
fund its employee stock ownership plan’s purchase of shares in the offering and
retained the remaining $2,792,000 for working capital.  Capital
raising costs were deferred and deducted from the proceeds of the shares sold in
the offering.




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 Bank). ORCA General,
Inc. originates mortgages that are purchased by the Bank for later sale on the
secondary market or for retention in the Bank’s portfolio. Material intercompany
balances have been eliminated in consolidation. The subsidiary has been inactive
since December 31, 2003. On May 19, 2003, the Bank, 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 and other real estate
owned.




63




ORGANIZATION
AND SIGNIFICANT ACCOUNTING POLICIES (CONT’D)




Cash - 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.




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.




Declines
in the fair value of available-for-sale securities below their cost that are
deemed to be other-than-temporary are reflected in earnings as realized losses.
Management periodically evaluates securities for other-than-temporary
impairment. In estimating other-than-temporary impairment losses, management
considers (1) the length of time and the extent to which the fair value has been
less than cost, (2) the financial condition and near-term prospects of the
issuer, and (3) the intent and ability of the Bank to retain its investment in
the issuer for the period of time sufficient to allow for any anticipated
recovery in fair value.




Loans - The Bank 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 Bank’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.




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.






64




ORGANIZATION
AND SIGNIFICANT ACCOUNTING POLICIES (CONT’D)




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 collectibility 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 nonclassified 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 Bank 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 Bank 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.




The
ultimate recovery of all loans is susceptible to future market factors beyond
the Bank’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 Bank’s allowance for credit losses, and may require the
Bank to make additions to the allowance based on their judgment about
information available to them at the time of their
examinations.


65






ORGANIZATION
AND SIGNIFICANT ACCOUNTING POLICIES (CONT’D)


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 Bank, (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 Bank does not maintain effective control over the transferred assets through
an agreement to repurchase them before their maturity.




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 Bank. 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.




Mortgage servicing rights -
The Bank 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.




Mortgage
servicing rights 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 Bank 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.




Restricted Equity Securities -
Restricted equity securities were $2.4 million and $1.4 million at December 31,
2008 and 2007, respectively. Federal Home Loan Bank of Seattle (“FHLB”) stock
amounted to $2.4 million and $1.4 million of the total restricted securities as
of December 31, 2008 and 2007, respectively. FHLB stock represents the Bank’s
investment in the FHLB of Seattle stock and is carried at par value, which
reasonably approximates its fair value. As a member of the FHLB system, the Bank
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, 2008, the Bank’s minimum required investment in FHLB
stock was $1.5 million. The Bank 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.












66






ORGANIZATION
AND SIGNIFICANT ACCOUNTING POLICIES (CONT’D)


Other Real Estate Owned and
Foreclosed Assets -Other real estate owned represents real estate which
the Bank has taken control of in partial or full satisfaction of loans. At the
time of foreclosure, other real estate owned and foreclosed 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, 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
income.





In some
instances, the Bank 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 SFAS No. 66,
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 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.





Deposits – At December 31,
2008 and 2007, deposits represent various accounts of the owners of the Bank.
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 Bank upon liquidation. Interest on
members’ deposits is based on available earnings at the end of an interest
period and is not guaranteed by the Bank. Interest rates are set by the Bank’s
Asset-Liability Management Committee.





Segment reporting - The Bank
operates in one segment and makes management decisions based on consolidated
results. The Bank’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 ordinary course
of business, the Bank has entered into commitments to extend credit, including
commitments under the credit card arrangements, commercial letters of credit,
and standby letters of credit. Such financial instruments are recorded when they
are funded.





Advertising costs - The Bank
expenses advertising costs as they are incurred. Advertising expenses were
$230,000 and $187,000, respectively for the years ended December 31, 2008 and
2007.














67


ORGANIZATION
AND SIGNIFICANT ACCOUNTING POLICIES (CONT’D)





Comprehensive income -
Accounting principles generally require that recognized revenue, expenses,
gains, and losses be included in net income. 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, are components of
comprehensive income.







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




2008
                        
                        
                        2007Unrealized
      holding gain (loss) on available-for-sale
      securities
                        
                        $
                        (1,204,005
                        )
                        
                        $
                        117Net
      unrealized losses
                        
                        
                        (1,204,005
                        )
                        
                        
                        117Tax
      effect
                        
                        
                        408,287
                        
                        
                        
                        -Net-of-tax
      amount
                        
                        $
                        (795,718
                        )
                        
                        $
                        117







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




2008
              
              
              2007Net
      unrealized gain (loss) onavailable-for-sale
      securities
              
              $
              (1,200,844
              )
              
              $
              3,161Tax
      effect
              
              
              408,287
              
              
              
              -Net-of-tax
      amount
              
              $
              (792,557
              )
              
              $
              3,161





Employee stock ownership plan
- The Bank sponsors a leveraged ESOP. Under Statement of Position No. 93-6,
Employers’ Accounting for
Employer Stock Ownership Plans, 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, 2008, there were 104,004 unallocated shares in the
plan.  Shares released on December 31, 2008 totaled 11,556 and will be
credited to plan participants’ accounts in 2009 (see Note 10).

















68







ORGANIZATION
AND SIGNIFICANT ACCOUNTING POLICIES (CONT’D)




Earnings Per Share -Basic
earnings per share is net income divided by the weighted average number of
common shares outstanding during the periods, which was 2,838,410 shares for the
year ended December 31, 2008, and there were no shares outstanding for the year
ended December 31, 2007.  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.





Recently Issued
Accounting Pronouncements -In December 2007, FASB issued SFAS No.
141 (revised),Business
Combinations. SFAS No. 141R
establishes principles and requirements for how an acquirer recognizes and
measures in its financial statements the identifiable assets acquired, the
liabilities assumed, any noncontrolling interest in the acquired entity and the
goodwill acquired. Furthermore, acquisition-related and other costs will now be
expensed rather than treated as cost components of the acquisition. SFAS No.
141R also establishes disclosure requirements to enable the evaluation of the
nature and financial effects of the business combination. This statement applies
prospectively to business


combinations for which the acquisition
date is on or after January 1, 2009. We do not expect the adoption of SFAS No.
141R will have a material impact on our consolidated financial statements as
related to business combinations consummated prior to January 1, 2009. We expect
the adoption of SFAS No. 141R will increase the costs charged to operations for
acquisitions consummated on or after January 1, 2009.





In June 2008, FASB issued FSP EITF
03-6-1,Determining Whether
Instruments Granted in Share-Based Payment Transactions Are Participating
Securities. FSP EITF 03-6-1
concludes that nonvested share-based payment awards that contain nonforfeitable
rights to dividends or dividend equivalents are participating securities and
shall be included in the computation of EPS pursuant to the two-class method.
This statement is effective for fiscal years beginning after December 15, 2008,
to be applied retrospectively. Certain of the Company’s nonvested restricted
stock awards qualify as participating


securities as described under this
pronouncement.





In October 2008, FASB issued FSP No.
157-3,Determining the Fair
Value of a Financial Asset When the Market for That Asset Is Not
Active. FSP No. 157-3
clarifies the application of SFAS 157 in a market that is not active and
provides an example to illustrate key considerations in determining the fair
value of a financial asset when the market for that financial asset is not
active. The FSP does not change existing generally accepted accounting
principles. This FSP was effective immediately upon issuance, including prior
periods for which financial statements have not been issued. The impact of
adoption did not have a material impact on the Company’s consolidated financial
statements.





On January 12, 2009, FASB issued FSP
EITF 99-20-1,Amendments to the
Impairment Guidance of EITF Issue No. 99-20. FSP EITF 99-20-1 addresses certain
practice issues in EITF No. 99-20,Recognition of
Interest Income and Impairment on Purchased Beneficial Interests and Beneficial
Interests That Continue to Be Held by a Transferor in Securitized Financial
Assets, by making its
other-than-


temporary impairment assessment guidance
consistent with SFAS No. 115,Accounting for
Certain Investments in Debt and Equity Securities. FSP EITF 99-20-1 removes the reference
to the consideration of a market participant’s estimates of cash flows in EITF
99-20, and instead requires an assessment of whether it is probable, based on
current information and events, that the holder of the security will be unable
to collect all amounts due according to the contractual terms. If it is probable
that there has been an adverse change in estimated cash flows, an
other-than-temporary impairment is deemed to exist, and a corresponding loss
shall be recognized in earnings equal to the entire difference between the
investment’s


69





ORGANIZATION
AND SIGNIFICANT ACCOUNTING POLICIES (CONT’D)


carrying value and its fair value at the
balance sheet date of the reporting period for which the assessment is made.
This FSP is effective for interim and annual reporting periods ending after
December 15, 2008, and shall be applied prospectively. The impact of adoption
did not have a material impact on the Company’s consolidated financial
statements.





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.





Subsequent
Event-Subsequent to year end the FDIC voted to amend the restoration plan for
the Deposit Insurance Fund (DIF).  The FDIC took action to ensure the
continued strength of the insurance fund by imposing a special assessment on
insured institutions, implementing changes to the risk-based assessment system
and setting rates beginning the second quarter of 2009.  The Bank has not
completed a full evaluation of the impact but believes its deposit insurance
premium assessments will increase from their current levels




2.           
CASH AND DUE FROM BANKS




Federal
Reserve Board regulations require that the Bank 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 $500,000 at
December 31, 2008 and 2007.




At
December 31, 2008 and 2007, $0 and $83,350, respectively, of interest-bearing
deposits at other financial institutions were restricted as part of the Bank’s
contract with its credit card service provider.






3.           INVESTMENTS




The
amortized cost and approximate fair value were as follows:




Gross
      Unrealized
                
                
                EstimatedAmortized
                
                
                
                
                
                Losses
      Less
                
                
                Losses
      Greater
                
                
                FairAFS
      Securities
                
                Cost
                
                
                Gains
                
                
                Than
      1 Year
                
                
                Than
      1 Year
                
                
                ValueDecember
      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
                )
                
                $
                -
                
                
                $
                8,929,798December
      31, 2007Agency
      mortgage-backed
                  securities
                
                $
                68,084
                
                
                $
                3,161
                
                
                $
                -
                
                
                $
                -
                
                
                $
                71,245





Management
evaluates on a quarterly basis each available-for-sale and held-to-maturity
investment security in an unrealized loss position to determine if the
impairment is temporary or other-than-temporary.  Management has
determined that none of our securities were other-than-temporarily impaired at
December 31, 2008.




70


INVESTMENTS
(CONT’D)




Investments
as of December 31, 2008, are mortgage-backed securities with contractual
maturities between 2022 and 2036. Expected maturities of mortgage-backed
securities may differ from contractual maturities because borrowers may have the
right to call or prepay the obligations.








AFS
      Securities
                  
                  Par
                  
                  
                  Amortized
                    Cost
                  
                  
                  Market
      Value
                  
                  
                  Unrealized
                    LossAgency
      mortgage backed-securities
                  
                  $
                  1,975,211
                  
                  
                  $
                  2,007,166
                  
                  
                  $
                  2,028,762
                  
                  
                  
                  -Non-agency
      mortgage backed securities
                  
                  $
                  8,729,154
                  
                  
                  $
                  8,123,476
                  
                  
                  
                  6,901,036
                  
                  
                  
                  (1,222,440
                  )$
                  10,704,365
                  
                  
                  $
                  10,130,642
                  
                  
                  $
                  8,929,798
                  
                  
                  
                  (1,222,440
                  )


At
December 31, 2008, the Bank had 8 securities with a gross unrealized loss
totaling $1.2 million in our available-for-sale portfolio with a fair value of
$6.9 million that had an unrealized loss for less than one year. 
Temporarily impaired securities have lower market values as a result of an
increase in credit spreads and are expected to regain their value as the
securities near maturity and/or credit spreads decline.




There
were no securities sold for the years ending December 31, 2008 and 2007,
respectively.




There
were $2,029,000 and $0 securities pledged to the Washington State Public Funds
at December 31, 2008 and December 31, 2007, respectively. There were $1,985,000
and $0 securities pledged to the FHLB of Seattle at December 31, 2008 and
December 31, 2007, respectively.






71






4.  LOANS




The
composition of the loan portfolio was as follows:




2008
              
              
              2007Real
      estate loansOne-
      to four-family
              
              $
              89,907,581
              
              
              $
              83,965,522Home
      equity
              
              
              54,556,779
              
              
              
              45,373,749Commercial
              
              
              48,729,582
              
              
              
              25,013,481Construction
      or development
              
              
              12,220,170
              
              
              
              8,621,743205,414,112
              
              
              
              162,974,495Consumer
      loansManufactured
      homes
              
              
              22,722,664
              
              
              
              22,495,034Automobile
              
              
              10,079,522
              
              
              
              15,077,564Other
              
              
              7,871,022
              
              
              
              8,818,01240,673,208
              
              
              
              46,390,610Commercial
      business loans
              
              
              17,667,965
              
              
              
              10,802,911263,755,285
              
              
              
              220,168,016Deferred
      loan origination (fees) costs
              
              
              (42,488
              )
              
              
              65,431Allowance
      for loan losses
              
              
              (1,305,950
              )
              
              
              (827,688
              )Total
      loans, net
              
              $
              262,406,847
              
              
              $
              219,405,759





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




2008
              
              
              2007Balance,
      beginning of year
              
              $
              827,688
              
              
              $
              822,393Provision
      for loan losses
              
              
              1,110,000
              
              
              
              250,000Loans
      charged off
              
              
              (791,089
              )
              
              
              (483,760
              )Recoveries
              
              
              159,351
              
              
              
              239,055Balance,
      end of year
              
              $
              1,305,950
              
              
              $
              827,688





There
were $1,252,000 and $418,000 of non-accrual loans at December 31, 2008 and 2007,
respectively.  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 and $59,000 in construction loans.
Additionally, we had non-accrual consumer and commercial business loans of
$63,000 and $61,000, respectively.  The Bank does not accrue interest
on loans past due 90 days or more.   If interest on these loans
had been accrued, such interest income would have been approximately $56,000 and
$12,000 for the years ended December 31, 2008 and 2007,
respectively.






72





LOANS
(CONT'D)




There were $4,577,000 of impaired loans at December 31, 2008 with
a total specific allocation of the allowance for loan losses of
$581,000.  There were $1,992,000 of impaired loans at December 31,
2007 with a total specific allocation of the allowance for loan losses of
$223,000. The average balance of impaired loans was $4,041,000 and $2,860,000
during 2008 and 2007. Interest income that would have been recognized on
impaired loans if not impaired was $56,000 and $12,000 during 2008 and 2007.
Additionally, at December 31, 2008, there were no commitments to lend additional
funds to borrowers whose loans were classified as non-accrual or impaired. 
Included in impaired loans at December 31, 2008 and 2007 were troubled debt
restructurings of $550,000 and $0, respectively.




As a
result of new or continuing delinquencies and ongoing credit evaluations during
the period subsequent to December 31, 2008, $1,144,000 of additional loans were
added to nonaccrual status and $1,027,000 of additional loans were subject to
troubled debt restructurings.





In the
ordinary course of business, the Bank 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, 2008 and 2007 totaled approximately $5,123,000 and $5,448,000,
respectively. During 2008, loan advances and repayments totaled approximately
$1,316,000 and $1,641,000 respectively, on these loans. During 2007, loan
advances and repayments totaled approximately $2,665,000 and $1,651,000,
respectively, on these loans.




On June
30, 2006, the Bank sold its credit card portfolio for approximately $13,900,000.
The gain recognized on the sale of the portfolio was approximately $2,300,000.
As part of the purchase and sale agreement, the Bank continued to service the
loans until January 19, 2007. The unpaid principal balances of loans
serviced related to the credit card portfolio as of December 31, 2008 and 2007
approximated $0 and $0, respectively.




At
December 31, 2008 and 2007, respectively, loans totaling $2,366,000 and $330,000
represent real estate secured loans that have loan-to-value ratios above
supervisory guidelines.




5.         LOAN
SERVICING




The
unpaid principal balances of loans serviced for Federal National Mortgage
Association (FNMA) at December 31, 2008 and 2007, totaled approximately
$141,499,000 and $132,829,000, respectively, and are not included in the Bank’s
financial statements.




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




2008
              
              
              2007Balance,
      beginning of year
              
              $
              864,946
              
              
              $
              867,562Servicing
      assets recognized during the year
              
              
              396,934
              
              
              
              247,481Amortization
      of servicing assets
              
              
              (341,608
              )
              
              
              (250,097
              )Valuation
      Allowance
              
              
              (57,126
              )
              
              
              -Balance,
      end of year
              
              $
              863,146
              
              
              $
              864,946







73






LOAN
SERVICING (CONT'D)




The fair
value of mortgage servicing rights was $863,146 and $1,248,590 at December 31,
2008 and 2007, respectively.




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




2008
              
              
              2007Prepayment
      speed (PSA)
              
              
              381
              %
              
              
              217
              %Weighted-average
      life (years)
              
              
              3.2
              
              
              
              5.1Yield
      to maturity discount rate
              
              
              9.0
              %
              
              
              10.0
              %




6.  PREMISES
AND EQUIPMENT




Premises
and equipment are summarized as follows:


2008
                
                
                
                2007Leasehold
      improvements
                
                $
                1,831,776
                
                
                $
                1,552,684Furniture
      and equipment
                
                
                1,927,094
                
                
                
                1,670,5713,758,870
                
                
                
                3,223,255Accumulated
      depreciation and amortization
                
                
                (2,222,128
                )
                
                
                (1,818,402
                )1,536,742
                
                
                
                1,404,853Fixed
      assets in process
                
                
                8,963
                
                
                
                -$
                1,545,705
                
                
                $
                1,404,853





Depreciation
and amortization expense for the years ended December 31, 2008 and 2007 amounted
to $404,382 and $331,551 respectively.




The Bank
leases office space in several buildings. Generally, operating leases contain
renewal options and provisions requiring the Bank 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,
                    
                    AMOUNT2009
                    
                    $
                    619,7552010
                    
                    
                    526,6262011
                    
                    
                    511,3252012
                    
                    
                    525,3562013
                    
                    
                    519,026Thereafter
                    
                    
                    2,572,025$
                    5,274,113









74






PREMISES
AND EQUIPMENT (CONT'D)




The total
rental expense for the years ended December 31, 2008 and 2007 for all
facilities leased under operating leases was approximately $627,000 and
$538,000, respectively.






7.  DEPOSITS




Deposits
are summarized as follows:




2008
              
              
              2007Savings
      accounts
              
              $
              13,109,252
              
              
              $
              11,696,050Checking
      accounts
              
              
              33,226,202
              
              
              
              45,289,355Money
      market accounts
              
              
              51,744,024
              
              
              
              39,754,145Time
      certificates of deposit accounts
              
              
              124,480,739
              
              
              
              106,051,649$
              222,560,217
              
              
              $
              202,791,199







Scheduled
maturities of time certificates of deposit are as follows:




YEAR
      ENDINGDECEMBER
      31,
                
                AMOUNT2009
                
                $
                90,145,6512010
                
                
                23,491,0552011
                
                
                7,646,5192012
                
                
                3,139,2692013
      and thereafter
                
                
                58,245$
                124,480,739






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, 2008 and 2007 was approximately $107,851,000 and $50,295,000,
respectively. During 2009, deposits in excess of $250,000 are not federally
insured, except for non-interest demand deposits, which are fully
insured.  After 2009, deposits in excess of $100,000 will not be
federally insured, unless the higher levels of insurance in effect in 2009 are
extended.




Deposits
from related parties held by the Bank at December 31, 2008 and December 31,
2007, amounted to $965,000 and $1,154,000, respectively.






75








DEPOSITS
(CONT'D)




Interest
expense by deposit category is as follows:




2008
              
              
              2007Savings
      accounts
              
              $
              121,450
              
              
              $
              130,603Checking
      accounts
              
              
              278,300
              
              
              
              320,855Money
      market accounts
              
              
              984,636
              
              
              
              1,478,458Time
      certificates of deposit accounts
              
              
              5,055,799
              
              
              
              4,648,518$
              6,440,185
              
              
              $
              6,578,434







8.
FHLB ADVANCES




The Bank
utilizes a loan agreement with the (FHLB) of Seattle. The terms of the agreement
call for a blanket pledge of a portion of the Bank’s mortgage portfolio based on
the outstanding balance. At December 31, 2008, the amount available to borrow
under this agreement is approximately 20% of total assets, conditional upon
meeting certain collateral and stock ownership requirements. The Bank had
outstanding borrowings under this arrangement of $42,219,355 and $15,869,355 at
December 31, 2008 and 2007, respectively.




Contractual
principal repayments are as follows:




YEAR
      ENDINGDECEMBER
      31,
                
                AMOUNT2009
                
                $
                22,219,3552010
                
                
                10,000,0002011
                
                
                10,000,000$
                42,219,355






2008
              
              
              2007
              
              
              2006(Dollars
      in thousands)Maximum
      balance:FHLB
      advances
              
              $
              56,119
              
              
              $
              34,519
              
              
              $
              24,485Average
      balances:FHLB
      advances
              
              $
              38,474
              
              
              $
              26,511
              
              
              $
              19,824Weighted
      average interest rate:FHLB
      advances
              
              
              2.73
              %
              
              
              4.63
              %
              
              
              4.84
              %







76






9.  EARNINGS
PER COMMON SHARE




The
following table presents the computation of basic and diluted earnings per share
for the year ended December 31:





Numerator:
                            
                            2008Net
      income
                            
                            $
                            261,575Denominator:Denominator
      for basic net income per share:Weighted
      average shares
                            
                            
                            2,838,410Effect
      of dilutive common stock equivalents
                            
                            
                            -Denominator
      for diluted net income per share
                            
                            
                            2,838,410Basic
      net income per share
                            
                            $
                            0.09Diluted
      net income per share
                            
                            $
                            0.09




For the
years ended December 31, 2008, there were no non-dilutive securities included in
the calculation for earnings per share.  Shares outstanding and earnings
per share information is not meaningful for prior periods.  The Company did
not complete their minority offering until January 8, 2008.




10.  EMPLOYEE
BENEFITS




The Bank
has a 401(k) pension plan that allows employees to defer a portion of their
salary into the 401(k) plan. The Bank contributes 1% of employees’ base salary
and matches a portion of employees’ salary deferrals. Pension costs are accrued
and funded on a current basis. The Bank contributed $117,000 and $98,000 to the
plan for the years ended December 31, 2008 and 2007, respectively.




The Bank
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 Bank and at December
31, 2008 and 2007 approximated $161,000 and $177,000, respectively. The Bank
contributed $13,000 and $11,000 to the plan for the years ended
December 31, 2008 and 2007, 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 Bank. 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






77






EMPLOYEE
BENEFITS (CONT'D)




without
cause or a change in control of the Bank, 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, 2008, the accrued liability for the
SERP was $264,000 and is included in other liabilities on the consolidated
balance sheet. The expense was $148,000 for the year ended December 31,
2008.




In 2008,
the board of directors adopted and shareholders approved an equity incentive
plan.  The plan permits the grant of restricted stock and stock
options. Under the plan 144,455 shares of common stock have been approved for
stock options and stock appreciation right and 57,782 shares of common stock
have been approved for restricted stock and restricted stock units. As of
December 31, 2008, the Bank had not issued any rewards under the plan and there
was no expense related to the plan for the year ended December 31,
2008.





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 Sound Financial, Inc. 2008
Equity Incentive Plan (the “Plan”). The Company granted 52,032 shares of
restricted stock to certain directors and employees. The Company also granted
25,998 non-qualified stock options and 82,400 incentive stock options to certain
directors and employees. The Plan was approved by shareholders at the special
meeting of shareholders held on November 19, 2008.





All of
the awards will 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 or the Bank.





In
January 2008, the Employee Stock Ownership Plan borrowed $1,155,600 from the
Company to purchase common stock of the Company. The loan is being repaid
principally from the Bank’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, 2008, the remaining balance of the ESOP loan was
$1,060,000.




At
December 31, 2008, the ESOP was committed to release 11,556 shares of the
Company’s common stock to participants and held 104,004 unallocated shares
remaining to be released in future years.  The fair value of the
104,004 restricted shares held by the ESOP trust was $741,000 at December 31,
2008.  ESOP compensation expense included in salaries and benefits was
$97,603 for the year ended December 31, 2008.




78




11.  INCOME
TAXES




The
components of the provision for income taxes are as follows:




2008
              
              
              2007Current
              
              $
              331,095
              
              
              $
              154,986Deferred
              
              
              (286,000
              )
              
              
              (93,000
              )Provision
      for income taxes
              
              $
              45,095
              
              
              $
              61,986




The
provision for federal income taxes differs from that computed at the statutory
tax rate of 34% as follows:




Provision
      at statutory rate
              
              $
              104,268
              
              
              $
              129,580Tax-exempt
      income
              
              
              (71,156
              )
              
              
              (67,754
              )Other
              
              
              11,983
              
              
              
              160$
              45,095
              
              
              $
              61,986Federal
      Tax Rate
              
              
              34.0
              %
              
              
              34.0
              %Tax
      exempt rate
              
              
              (23.2
              )
              
              
              (17.8
              )Other
              
              
              3.9
              
              
              
              0.1Effective
      tax rate
              
              
              14.7
              %
              
              
              16.3
              %







The
Bank’s total net deferred tax asset (liability), included on the consolidated
balance sheets in accounts payable and other liabilities or in other assets, is
as follows:




Deferred
      tax assetsDeferred
      compensation
                
                $
                144,000
                
                
                $
                100,000Unrealized
      loss on securities
                
                
                408,000
                
                
                
                -Nonaccrual
      interest
                
                
                19,000
                
                
                
                4,000Charitable
      contributions
                
                
                58,000
                
                
                
                -Allowance
      for loan losses
                
                
                115,000
                
                
                
                (73,000
                )Other,
      net
                
                
                19,000
                
                
                
                -Total
      deferred tax assets
                
                
                763,000
                
                
                
                31,000Deferred
      tax liabilitiesFHLB
      stock
                
                
                142,000
                
                
                
                142,000Prepaid
      expenses
                
                
                36,000
                
                
                
                57,000Depreciation
                
                
                70,000
                
                
                
                (12,000
                )Unrealized
      gain on securities
                
                
                -
                
                
                
                1,000Deferred
      loan fees and costs
                
                
                253,000
                
                
                
                276,000Total
      deferred tax liabilities
                
                
                501,000
                
                
                
                464,000Net
      deferred tax asset (liability)
                
                $
                262,000
                
                
                $
                (433,000
                )







79







INCOME
TAXES (CONT’D)




The
Company adopted the provisions of FASB Interpretation No. 48, 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 January 1, 2007 and at December 31, 2008.




The
Company recognizes interest accrued and penalties related to unrecognized tax
benefits in tax expense.  During the years ended December 31, 2008 and
2007, the Company recognized no interest and penalties.




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 2005.




The
Company has a contribution carryforward for tax reporting
purposes.  The approximate amount of this carryforward as of December
31, 2008 is $170,000 eligible to off set future federal income
taxes.  The contribution carryforward will expire in 2013 if not
utilized.




12.  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
Bank’s financial statements. The regulations require the Bank to meet specific
capital adequacy guidelines that involve quantitative measures of the Bank’s
assets, liabilities, and certain off-balance-sheet items as calculated under
regulatory accounting practices. The Bank’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 Bank
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, 2008 and 2007, the Bank meets all capital adequacy requirements to
which it is subject.




As of
December 31, 2008, the most recent notification from the Federal Deposit
Insurance Corporation categorized the Bank 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 Bank’s category.




The Bank
declared a dividend of $0.04 per common share on January 28, 2009. The dividend
will be paid on February 25, 2009 to shareholders of record on February 10,
2009.


80




MINIMUM
REGULATORY CAPITAL REQUIREMENTS (CONT’D)




The
Bank’s actual capital amounts (in thousands) and ratios as of December 31, 2008
and 2007 are presented in the following table:




To
      Be Well CapitalizedFor
      Capital
                
                Under
      Prompt CorrectiveActual
                
                Adequacy
      Purposes
                
                Action
      ProvisionsAmount
                
                Ratio
                
                Amount
                
                Ratio
                
                Amount
                
                RatioAs
      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%As
      of December 31, 2007Total
      Capital(to
      Risk-Weighted Assets)
                $16,716
                
                10.52%
                
                $12,708
                >
                8.0%
                
                $15,885
                >
                10.0%Tier
      I Capital(to
      Risk-Weighted Assets)
                $15,885
                
                10.00%
                
                $6,354
                >
                4.0%
                
                $ 9,531
                >
                6.0%Tier
      I Capital(to
      Average Assets)
                $15,885
                
                6.70%
                
                $9,479
                >
                4.0%
                
                $11,848
                >
                5.0%





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




2008
              
              
              2007Equity
              
              $
              23,587
              
              
              $
              15,888Accumulated
      other comprehensive(income)
      loss
              
              
              793
              
              
              
              (3
              )Total
      Tier 1 capital
              
              $
              24,380
              
              
              $
              15,885Allowance
      for loan and lease losses
              
              $
              1,306
              
              
              $
              828Unrealized
      gain on AFS securities
              
              
              -
              
              
              
              3Total
      capital
              
              $
              25,686
              
              
              $
              16,716







81






13.  FAIR
VALUE OF FINANCIAL INSTRUMENTS




SFAS No.
107, Disclosures About Fair
Value of Financial Instruments, requires disclosure of fair value
information about financial instruments for which it is practicable to estimate
fair value. As defined by SFAS No. 107, the following methods and assumptions
were used to estimate fair value of each class of financial instruments listed
below:




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.




Securities - Estimated
fair values for securities are obtained from quoted market prices where
available. Where quoted market prices are not available, estimated fair values
are based on matrix pricing models provided by an outside independent
source.




Loans - The estimated fair
value for all fixed rate loans (including loans held-for-sale) 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.




Mortgage Servicing
Rights:




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




Deposits - The estimated fair
value of deposit accounts (savings, checking, 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.




FHLB advances - The fair
values 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 values 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.






82






FAIR
VALUE OF FINANCIAL INSTRUMENTS (CONT'D)




The
estimated fair value of the Bank’s financial instruments is summarized as
follows:




2008
                
                
                2007Carrying
                
                
                Fair
                
                
                Carrying
                
                
                FairAmount
                
                
                Value
                
                
                Amount
                
                
                ValueFinancial
      assetsCash
      and cash equivalents
                
                $
                5,607,800
                
                
                $
                5,607,800
                
                
                $
                6,104,963
                
                
                $
                6,104,963Securities available-for-sale
                
                $
                8,929,798
                
                
                $
                8,929,798
                
                
                $
                71,245
                
                
                $
                71,245Mortgage
      servicing rights
                
                $
                920,271
                
                
                $
                863,146
                
                
                $
                864,946
                
                
                $
                1,248,711FHLB
      stock
                
                $
                2,444,000
                
                
                $
                2,444,000
                
                
                $
                1,319,500
                
                
                $
                1,319,500Loans,
      net
                
                $
                263,362,442
                
                
                $
                263,167,112
                
                
                $
                219,405,759
                
                
                $
                218,709,207Accrued
      interest receivable
                
                $
                1,219,645
                
                
                $
                1,219,645
                
                
                $
                1,051,476
                
                
                $
                1,051,476Financial
      liabilitiesDemand
      deposits
                
                $
                98,079,478
                
                
                $
                98,079,478
                
                
                $
                96,739,550
                
                
                $
                96,739,550Time
      deposits
                
                $
                124,480,739
                
                
                $
                123,280,368
                
                
                $
                106,051,649
                
                
                $
                106,504,696FHLB
      advances
                
                $
                42,419,355
                
                
                $
                41,909,153
                
                
                $
                15,869,355
                
                
                $
                15,884,249Accrued
      interest payable
                
                $
                259,757
                
                
                $
                259,757
                
                
                $
                210,518
                
                
                $
                210,518Advance
      payments fromborrowers
      for taxesand
      insurance
                
                $
                330,318
                
                
                $
                330,318
                
                
                $
                254,213
                
                
                $
                254,213







The Bank
assumes interest rate risk (the risk that general interest rate levels will
change) as a result of its normal operations. As a result, the fair values of
the Bank’s financial instruments will change when interest rate levels change,
and that change may be either favorable or unfavorable to the Bank. Management
attempts to match maturities of assets and liabilities to the extent believed
necessary 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 adjusting terms of new loans and deposits and
by investing in securities with terms that mitigate the Bank’s overall interest
rate risk.




As
discussed in Note 1, FAS 157 defines fair value as the exchange price that would
be received for an asset or paid to transfer a liability (an exit price) in the
principal or most advantageous market for the asset or liability in an orderly
transaction between market participants on the measurement date.  FAS
157 also establishes a fair value hierarchy which requires an entity to maximize
the use of observable inputs and minimize the use of unobservable inputs when
measuring fair value. The standard describes three levels of inputs that may be
used to measure fair value:




Level 1: Quoted prices
(unadjusted) for identical assets or liabilities in active exchange markets that
the entity has the ability to access as of the measurement date.




Level 2: Significant other
observable inputs other than Level 1 prices, such as quoted prices for similar
assets or liabilities, quoted prices in markets that are not active and other
inputs that are observable or can be corroborated by observable market
data.






83






FAIR VALUE OF FINANCIAL INSTRUMENTS
(CONT'D)




Level 3: Significant
unobservable inputs that reflect a company’s own assumptions about the
assumptions that market participants would use in pricing an asset or
liability.





The
following is a description of the valuation methodologies used to measure and
report fair value of financial assets and liabilities on a recurring or
nonrecurring basis:





In
determining the appropriate levels, the Company performs a detailed analysis of
the assets and liabilities that are subject to SFAS No. 157. In certain cases,
the inputs used to measure fair value of an asset or liability may fall into
different levels of the fair value hierarchy. The level within which the fair
value measurement is categorized is based on the lowest level input that is
significant to the fair value measurement in its entirety. Therefore, an item
may be classified in Level 3 even though there may be some significant inputs
that are readily observable.





Valuation
Methodologies





A
description of the valuation methodologies used for certain financial assets and
financial liabilities measured at fair value is as follows:





Securities Available for Sale:
Securities available for sale 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. Level 1 securities include those traded on an active
exchange, as well as U.S. government and its agencies securities. Level 2
securities include mortgage-backed securities and certain asset-backed
securities. Level 3 securities include collateralized mortgage obligations
(CMOs).





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, 2008, loans held for sale were carried at
cost.





Mortgage Servicing
Rights:The fair value of
mortgage servicing rights is estimated using a discounted cash flow
model. These assets are classified as Level 3. At December 31, 2008,
mortgage servicing rights are carried at fair market value.





Impaired
Loans:From time to time, and on a nonrecurring
basis, fair value adjustments to collateral dependent loans are recorded to
reflect partial write-downs based on the current appraised value of the
collateral or internally developed models which contain management’s
assumptions.




Other Real Estate
Ownedand Foreclosed
Assets:Other real estate ownedand foreclosed assetsconsists principally of properties
acquired through foreclosureor repossessionand 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.






84




FAIR VALUE OF FINANCIAL INSTRUMENTS
(CONT'D)




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
      3Available
      for Sale Securities
            $8,929,798
            $               -
            $5,676,787
            $        3,253,011





The
following table presents the balance of assets measured at fair value on a
nonrecurring basis at December 31, 2008, and the total losses resulting from
these fair value adjustments for the twelve months ended December 31,
2008:





Fair
      Value at December 31, 2008
            December
      31, 2008Description
            Total
            Level
      1
            Level
      2
            Level
      3
            Total
      LossesMortgage
      Servicing Rights
            $   863,146
            $              -
            $   863,146
            $            
      -
            $            57,126OREO
      and Foreclosed Assets
            $1,724,567
            $              -
            $             -
            $1,724,567
            $            33,500Impaired
      Loans
            $4,577,080
            $              -
            $             -
            $4,577,080
            $          581,177





For mortgage servicing rights,
the loss
representsthe difference
between amortized cost and the net present value of future cash flows. For
impaired loans, theimpairments on collateral dependent
loans for fair value adjustments based on the fair value of the
collateral.





There
were no material liabilities carried at fair value, measured on a recurring or
nonrecurring basis, at December 31, 2008.




14.
CONCENTRATIONS OF CREDIT RISK




Most of
the Bank’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 Bank’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 Bank’s equity, excluding accumulated other
comprehensive income (loss).




15.
COMMITMENTS AND CONTINGENT LIABILITIES




The Bank
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
Bank’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. The Bank
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






85








COMMITMENTS
AND CONTINGENT LIABILITIES (CONT'D)




expire
without being drawn upon, the total commitment amounts do not necessarily
represent future cash requirements. The Bank evaluates each customer’s
creditworthiness on a case-by-case basis. The amount of collateral obtained, if
it is deemed necessary by the Bank, is based on management’s credit evaluation
of the customer.




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




2008
              
              
              2007Unused
      home equity lines of credit
              
              $
              22,959,662
              
              
              $
              19,989,961Unused
      personal line of credit
              
              
              2,856,705
              
              
              
              3,192,912Unused
      business line of credit
              
              
              6,312,060
              
              
              
              9,171,216Undisbursed
      portion of loans closed
              
              
              1,811,247
              
              
              
              2,324,413Irrevocable
      letters of credit
              
              
              2,283,450
              
              
              
              1,575,000Residential
      mortgage commitments
              
              
              5,608,700
              
              
              
              1,406,242$
              41,831,824
              
              
              $
              37,659,744





At
December 31, 2008, fixed rate loan commitments totaled $3,196,500 and had a
weighted average interest rate of 4.80%. At December 31, 2007, fixed rate loan
commitments totaled $1,406,242 and had a weighted average interest rate of
6.22%.




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


In the
ordinary course of business, the Bank 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 Bank may be required to either repurchase the
loan or indemnify the investor for losses sustained. If there are not defects,
the Bank has no commitment to repurchase the loan. As of December 31, 2008 and
2007, the maximum amount of these guarantees totaled $141,499,000 and
$132,829,000, respectively. These amounts represent the unpaid principal
balances of the Bank’s loans serviced for others’ portfolios. The Bank has
recorded no reserve to cover loss exposure related to these guarantees. In
January 2007, the Bank received a request from Fannie Mae to repurchase one loan
that was not fully conforming to their standards. The amount of the loan
repurchased was approximately $154,000 and the Bank recorded a loss of $750 on
the repurchase transaction. No loans were repurchased for the year ended
December 31, 2008.




The Bank
pays certain medical, dental, prescription, and vision claims for its employees,
on a self-insured basis. The Bank 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, 2008 and 2007.




At
various times, the Bank 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 Bank 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.






86






COMMITMENTS AND CONTINGENT
LIABILITIES (CONT'D)




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 are 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 Bank’s membership
interest in Visa, Inc.




Previously,
Visa announced that it completed restructuring transactions in preparation for
an initial public offering of its Class A stock planned for early 2008,
and, as part of those transactions, Sound Financial’s membership interest was
exchanged for Class B stock of Visa. In March 2008, Visa completed its initial
public offering. Using the proceeds from this offering, Visa established a $3.0
billion escrow account to cover settlements, resolution of pending litigation
and related claims (“covered litigation”).





As a
result of Visa’s initial public offering, we received $154,000 in proceeds from
a mandatory partial redemption of our restricted Class B common stock, which is
recorded in gain on sale of investment. As of December 31, 2008, the Company
owns 5,699 shares of Class B common stock. These shares are restricted and may
not be transferred until the later of (1) three years from the date of the
initial public offering or (2) the period of time necessary to resolve the
covered litigation. A conversion ratio of 0.71429 was 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 October 2008, Visa announced that it
had reached a settlement with Discover Card related to an antitrust lawsuit. The
Bank and other Visa member banks are obligated to fund the settlement and share
in losses resulting from this litigation that are not already provided for in
the escrow account. Visa notified the Company that it had established an
additional reserve related to the settlement with Discover Card that has not
already been funded into the escrow account. The Company is not a party to the
Visa litigation and its liability arises solely from the Bank’s membership interest in
Visa.




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.










87







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, 2008, 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.  Our Chief Executive Officer
and Principal Financial Officer concluded that, as of December 31, 2008, 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)           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.


88




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, 2008.  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, 2008, 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, 2008, that have materially affected, or as reasonably likely to
materially affect, our internal control over financial reporting.




Item
9B.   Other Information




None.





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 2009, 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.


89




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 2008, 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.




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.




Scott V.
Boyer became Senior Vice President-Retail Banking on July 1, 2008.  A
Form 3 reflecting his appointment as an executive officer who owned no shares
should have been filed on or before July 11, 2008, but was not filed until
November 7, 2008.




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, 2008, all Section 16(a)
filing requirements applicable to its officers, directors and greater than 10%
beneficial owners (except with respect to Mr. Boyer’s late filing) were complied
with.




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 2009,






90








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 2009, 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.


91




The
following table sets forth information as of December 31, 2008, with respect to
compensation plans under which shares of common stock were issued.




Equity
Compensation Plan Information







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
            
            ---(1)
            
            $       ---
            
            202,237(2)Equity
      Incentive Plan Not
              Approved
      by Security Holders
            
            ---
            
            ---
            
            ---




(1)
            On
      October 10, 2008, the Company’s shareholders approve an equity incentive
      plan providing for the issuance of stock options, restricted stock and
      stock appreciation rights.  No awards were made under this plan
      in 2008.  However a number of awards were made on January 27,
      2009.




(2)
            Consists
      of stock options and stock appreciation rights covering up to 144,455
      shares of common stock and restricted stock and restricted stock units
      covering up to 57,782 shares of common
stock.




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 2009, 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 2009, 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.







92


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, 2008 and 2007Consolidated
      Statements of Income for the Years Ended December 31, 2008 and
      2007Consolidated
      Statements of Stockholders' Equity for the Years Ended December 31,
              2008,and
      2007Consolidated
      Statements of Cash Flows for the Years Ended December 31, 2008 and
      2007Notes
      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.








93




(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
            
            10.810.9
            
            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
            
            +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.  Such previously filed document is
      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.  Such previously filed document is 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.  Such previously filed document is incorporated herein by
      reference in accordance with Item 601 of Regulation
  S-K.


+
            Filed
      as an Exhibit to the Company’s Form 8K filed on January 29,
      2009.  Such previously filed document in incorporated herein by
      reference in accordance with Item 601 of Regulation
  S-K.




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




(c)  Financial
Statements Schedules - None


94


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
      30, 2009
            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
      30, 2009
                    
                    Date:  March
      30, 2009/s/David S. Haddad,
      Jr.
                    
                    /s/Robert F.
      CarneyDavid S. Haddad, Jr.,
      Director
                    
                    Robert F. Carney,
      DirectorDate:  March
      30, 2009
                    
                    Date:  March
      30, 2009/s/Debra Jones
                    
                    /s/Milton L.
      McMullenDebra Jones,
      Director
                    
                    Milton L. McMullen,
      DirectorDate:  March
      30, 2009
                    
                    Date:  March
      30, 2009/s/Rogelio
      Riojas
                    
                    /s/James E.
      SweeneyRogelio Riojas,
      Director
                    
                    James E. Sweeney,
      DirectorDate:   March
      30, 2009
                    
                    Date:  March
      30, 2009/s/ Matthew P. DeinesMatthew
      P. Deines, Executive Vice Presidentand
      Chief Financial Officer(Principal Financial and
      Accounting Officer)Date:  March
      30, 2009


95












INDEX
TO EXHIBITS








Number
                Description10.7
                Director
      Fee Arrangements for 200910.8
                Sound
      Financial Inc. 2008 Equity Incentive Plan23
                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