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, 2007OR[  ]
            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:


Title of each
class                                                                              Name
of each exchange on which registered


Common Stock, par value
$.01 per share       None




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




None





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. [X]




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.  (Check one)




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,
2007, the last business day of the registrant’s most recently completed second
fiscal quarter, was $0.




As of
March 17, 2008, there were issued and outstanding 2,948,063 shares of the
registrant’s common stock.





DOCUMENTS
INCORPORATED BY REFERENCE




PART III
of Form 10-K--Portions of registrant’s Proxy Statement for its 2008 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, Sound Financial’s
assets consist of all of the outstanding shares of common stock of Sound
Community Bank, $3 million in cash and a loan to the Sound Financial employee
stock ownership plan.  Sound Financial has no significant
liabilities.  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 $882,000 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 $2,934,000 for working
capital.  As the MHC reorganization and stock offering were completed
subsequent to the year ended December 31, 2007, the information in this document
relates primarily to the Bank, except as otherwise indicated.




At
December 31, 2007, the Company had total assets of $237 million, deposits of
$203 million and stockholders’ equity of $16 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."




The
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 as a credit union 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 employee groups.  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.




Our
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), and commercial real estate, consumer loans
and, to a lesser extent, construction and development loans and commercial
business loans.  We offer a wide variety of secured and unsecured
consumer loan products, including manufactured home loans, automobile loans, and
boat and recreational vehicle loans.




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 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.




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.  See “-
Competition.”




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 Boeing, Microsoft, Costco,
Nordstrom, Amazon.com, Starbucks, Safeco, Washington Mutual and
Weyerhaeuser.






2






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 July 2007, our market area reported an unemployment rate of 4.1%, as
compared to the national average of 4.6%, 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 construction and commercial
lending.




























3


Lending
Activities




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




2007
            
            
            2006
            
            
            2005
            
            
            2004
            
            
            2003Amount
            
            
            Percent
            
            
            Amount
            
            
            Percent
            
            
            Amount
            
            
            Percent
            
            
            Amount
            
            
            Percent
            
            
            Amount
            
            
            PercentReal
      estate loans:One-
      to four-family
            
            $
            84,788
            
            
            
            38.37
            %
            
            $
            86,102
            
            
            
            41.60
            %
            
            $
            75,554
            
            
            
            39.34
            %
            
            $
            67,599
            
            
            
            42.55
            %
            
            $
            65,856
            
            
            
            49.22
            %Home
      equity
            
            
            45,374
            
            
            
            20.53
            
            
            
            39,302
            
            
            
            18.99
            
            
            
            28,534
            
            
            
            14.86
            
            
            
            23,841
            
            
            
            15.01
            
            
            
            18,450
            
            
            
            13.79Commercial
            
            
            25,013
            
            
            
            11.32
            
            
            
            17,501
            
            
            
            8.46
            
            
            
            15,548
            
            
            
            8.10
            
            
            
            15,042
            
            
            
            9.47
            
            
            
            11,446
            
            
            
            8.55Construction
      or development
            
            
            8,622
            
            
            
            3.90
            
            
            
            9,459
            
            
            
            4.57
            
            
            
            7,777
            
            
            
            4.05
            
            
            
            5,163
            
            
            
            3.25
            
            
            
            2,747
            
            
            
            2.05Total real estate
      loans
            
            
            163,797
            
            
            
            74.12
            
            
            
            152,364
            
            
            
            73.62
            
            
            
            127,413
            
            
            
            66.35
            
            
            
            111,645
            
            
            
            70.27
            
            
            
            98,499
            
            
            
            73.61Consumer
      loans:Manufactured
      homes
            
            
            22,495
            
            
            
            10.18
            
            
            
            19,785
            
            
            
            9.56
            
            
            
            16,648
            
            
            
            8.67
            
            
            
            9,702
            
            
            
            6.11
            
            
            
            2,357
            
            
            
            1.76Automobile
            
            
            15,078
            
            
            
            6.82
            
            
            
            17,272
            
            
            
            8.35
            
            
            
            18,138
            
            
            
            9.44
            
            
            
            15,964
            
            
            
            10.05
            
            
            
            14,835
            
            
            
            11.09Credit
      Card
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            12,196
            
            
            
            6.35
            
            
            
            11,747
            
            
            
            7.39
            
            
            
            11,929
            
            
            
            8.92Other
            
            
            8,818
            
            
            
            3.99
            
            
            
            9,932
            
            
            
            4.79
            
            
            
            6,478
            
            
            
            3.37
            
            
            
            5,223
            
            
            
            3.29
            
            
            
            3,577
            
            
            
            2.67Total consumer
      loans
            
            
            46,391
            
            
            
            20.99
            
            
            
            46,989
            
            
            
            22.71
            
            
            
            53,460
            
            
            
            27.84
            
            
            
            42,636
            
            
            
            26.84
            
            
            
            32,698
            
            
            
            24.44Commercial
      business loans
            
            
            10,803
            
            
            
            4.89
            
            
            
            7,600
            
            
            
            3.67
            
            
            
            11,168
            
            
            
            5.82
            
            
            
            4,588
            
            
            
            2.89
            
            
            
            2,608
            
            
            
            1.95Total
      loans
            
            
            220,991
            
            
            
            100.00
            %
            
            
            206,953
            
            
            
            100.00
            %
            
            
            192,041
            
            
            
            100.00
            %
            
            
            158,869
            
            
            
            100.00
            %
            
            
            133,805
            
            
            
            100.00
            %Less:Deferred
      fees and discounts
            
            
            (65
            )
            
            
            
            
            
            
            12
            
            
            
            
            
            
            
            185
            
            
            
            
            
            
            
            131
            
            
            
            
            
            
            
            125Loans
      held for sale
            
            
            822
            
            
            
            
            
            
            
            1,307
            
            
            
            
            
            
            
            1,069
            
            
            
            
            
            
            
            ---
            
            
            
            
            
            
            
            ---Allowance
      for losses
            
            
            828
            
            
            
            
            
            
            
            822
            
            
            
            
            
            
            
            1,321
            
            
            
            
            
            
            
            1,033
            
            
            
            
            
            
            
            826Total loans,
      net
            
            $
            219,406
            
            
            
            
            
            
            $
            204,812
            
            
            
            
            
            
            $
            189,466
            
            
            
            
            
            
            $
            157,705
            
            
            
            
            
            
            $
            132,854




















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.





2007
            
            
            2006
            
            
            2005
            
            
            2004
            
            
            2003Amount
            
            
            Percent
            
            
            Amount
            
            
            Percent
            
            
            Amount
            
            
            Percent
            
            
            Amount
            
            
            Percent
            
            
            Amount
            
            
            PercentFixed-
      rate loans:Real
      estate loans:One- to
      four-family(1)
            
            $
            66,335
            
            
            
            30.02
            %
            
            $
            74,159
            
            
            
            35.83
            %
            
            $
            69,100
            
            
            
            35.98
            %
            
            $
            63,725
            
            
            
            40.11
            %
            
            $
            63,014
            
            
            
            47.09
            %Home
      equity
            
            
            17,814
            
            
            
            8.05
            
            
            
            18,159
            
            
            
            8.77
            
            
            
            7,655
            
            
            
            3.99
            
            
            
            6,304
            
            
            
            3.97
            
            
            
            4,361
            
            
            
            3.26Commercial
            
            
            17,250
            
            
            
            7.81
            
            
            
            12,000
            
            
            
            5.80
            
            
            
            11,088
            
            
            
            5.77
            
            
            
            7,813
            
            
            
            4.92
            
            
            
            5,301
            
            
            
            3.96Construction
      or development
            
            
            5,583
            
            
            
            2.53
            
            
            
            7,056
            
            
            
            3.41
            
            
            
            3,461
            
            
            
            1.80
            
            
            
            1,788
            
            
            
            1.13
            
            
            
            1,302
            
            
            
            0.97Total real estate
      loans
            
            
            106,982
            
            
            
            48.41
            
            
            
            111,374
            
            
            
            53.82
            
            
            
            91,304
            
            
            
            47.54
            
            
            
            79,630
            
            
            
            50.12
            
            
            
            73,978
            
            
            
            55.29Manufactured
      homes
            
            
            22,495
            
            
            
            10.18
            
            
            
            19,785
            
            
            
            9.56
            
            
            
            16,648
            
            
            
            8.67
            
            
            
            9,702
            
            
            
            6.11
            
            
            
            2,357
            
            
            
            1.76Automobile
            
            
            15,078
            
            
            
            6.82
            
            
            
            17,272
            
            
            
            8.35
            
            
            
            18,138
            
            
            
            9.44
            
            
            
            15,964
            
            
            
            10.05
            
            
            
            14,835
            
            
            
            11.09Credit
      card
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            3,138
            
            
            
            1.63
            
            
            
            5,595
            
            
            
            3.52
            
            
            
            5,207
            
            
            
            3.89Other
      consumer
            
            
            7,119
            
            
            
            3.22
            
            
            
            9,148
            
            
            
            4.42
            
            
            
            5,755
            
            
            
            3.00
            
            
            
            4,421
            
            
            
            2.78
            
            
            
            2,754
            
            
            
            2.06Commercial
      business loans
            
            
            5,539
            
            
            
            2.51
            
            
            
            4,121
            
            
            
            1.99
            
            
            
            3,750
            
            
            
            1.95
            
            
            
            1,674
            
            
            
            1.05
            
            
            
            1,401
            
            
            
            1.05Total fixed-rate
      loans
            
            
            157,213
            
            
            
            71.14
            
            
            
            161,700
            
            
            
            78.13
            
            
            
            138,733
            
            
            
            72.24
            
            
            
            116,986
            
            
            
            73.64
            
            
            
            100,532
            
            
            
            75.13Adjustable-
      rate loans:Real
      estate loans:One-
      to four-family
            
            
            18,453
            
            
            
            8.35
            
            
            
            11,942
            
            
            
            5.77
            
            
            
            6,453
            
            
            
            3.36
            
            
            
            3,875
            
            
            
            2.44
            
            
            
            2,842
            
            
            
            2.12Home
      equity
            
            
            27,560
            
            
            
            12.47
            
            
            
            21,143
            
            
            
            10.22
            
            
            
            20,879
            
            
            
            10.87
            
            
            
            17,537
            
            
            
            11.04
            
            
            
            14,089
            
            
            
            10.53Commercial
            
            
            7,764
            
            
            
            3.51
            
            
            
            5,502
            
            
            
            2.66
            
            
            
            4,460
            
            
            
            2.32
            
            
            
            7,228
            
            
            
            4.55
            
            
            
            6,145
            
            
            
            4.59Construction
      or development
            
            
            3,039
            
            
            
            1.38
            
            
            
            2,403
            
            
            
            1.16
            
            
            
            4,316
            
            
            
            2.25
            
            
            
            3,375
            
            
            
            2.12
            
            
            
            1,445
            
            
            
            1.08Total real estate
      loans
            
            
            56,816
            
            
            
            25.71
            
            
            
            40,990
            
            
            
            19.81
            
            
            
            36,108
            
            
            
            18.80
            
            
            
            32,015
            
            
            
            20.15
            
            
            
            24,521
            
            
            
            18.33Credit
      card
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            9,058
            
            
            
            4.72
            
            
            
            6,152
            
            
            
            3.87
            
            
            
            6,722
            
            
            
            5.02Other
      consumer
            
            
            1,698
            
            
            
            0.77
            
            
            
            784
            
            
            
            0.38
            
            
            
            724
            
            
            
            0.38
            
            
            
            802
            
            
            
            0.50
            
            
            
            823
            
            
            
            0.62Commercial
      business loans
            
            
            5,264
            
            
            
            2.38
            
            
            
            3,479
            
            
            
            1.68
            
            
            
            7,418
            
            
            
            3.86
            
            
            
            2,914
            
            
            
            1.83
            
            
            
            1,207
            
            
            
            0.90Total adjustable-rate
      loans
            
            
            63,778
            
            
            
            28.86
            
            
            
            45,253
            
            
            
            21.87
            
            
            
            53,308
            
            
            
            27.76
            
            
            
            41,883
            
            
            
            26.36
            
            
            
            33,273
            
            
            
            24.87Total
      loans
            
            
            220,991
            
            
            
            100.00
            %
            
            
            206,953
            
            
            
            100.00
            %
            
            
            192,041
            
            
            
            100.00
            %
            
            
            158,869
            
            
            
            100.00
            %
            
            
            133,805
            
            
            
            100.00
            %Less:Deferred
      fees and discounts
            
            
            (65
            )
            
            
            
            
            
            
            12
            
            
            
            
            
            
            
            185
            
            
            
            
            
            
            
            131
            
            
            
            
            
            
            
            125Loans
      held for sale
            
            
            822
            
            
            
            
            
            
            
            1,307
            
            
            
            
            
            
            
            1,069
            
            
            
            
            
            
            
            ---
            
            
            
            
            
            
            
            ---Allowance
      for losses
            
            
            828
            
            
            
            
            
            
            
            822
            
            
            
            
            
            
            
            1,321
            
            
            
            
            
            
            
            1,033
            
            
            
            
            
            
            
            826Total loans,
      net
            
            $
            219,406
            
            
            
            
            
            
            $
            204,812
            
            
            
            
            
            
            $
            189,466
            
            
            
            
            
            
            $
            157,705
            
            
            
            
            
            
            $
            132,854


______________________________


(1)
Includes
30-year loans with a one-time rate adjustment five to seven years after
origination, which at December 31, 2007, totaled $32 million, or 48.9% of our
fixed-rate residential mortgages.


5







The
following schedule illustrates the contractual maturity of our loan portfolio at
December 31, 2007.  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)2008(1)
            
            $
            1,656
            
            
            
            5.61
            %
            
            $
            489
            
            
            
            9.14
            %
            
            $
            6,573
            
            
            
            7.21
            %
            
            $
            5,365
            
            
            
            7.51
            %
            
            $
            1,314
            
            
            
            13.39
            %
            
            $
            5,099
            
            
            
            8.48
            %
            
            $
            20,496
            
            
            
            7.92
            %2009
            
            
            2,614
            
            
            
            5.51
            
            
            
            186
            
            
            
            6.16
            
            
            
            1,601
            
            
            
            7.29
            
            
            
            937
            
            
            
            10.25
            
            
            
            1,644
            
            
            
            7.25
            
            
            
            1,049
            
            
            
            8.53
            
            
            
            8,031
            
            
            
            7.182010
            
            
            7,878
            
            
            
            4.84
            
            
            
            226
            
            
            
            6.15
            
            
            
            800
            
            
            
            7.15
            
            
            
            ---
            
            
            
            ---
            
            
            
            3,051
            
            
            
            7.46
            
            
            
            678
            
            
            
            8.20
            
            
            
            12,633
            
            
            
            5.822011
            
            
            5,193
            
            
            
            5.62
            
            
            
            515
            
            
            
            6.07
            
            
            
            559
            
            
            
            6.00
            
            
            
            ---
            
            
            
            ---
            
            
            
            4,881
            
            
            
            7.15
            
            
            
            292
            
            
            
            9.03
            
            
            
            11,440
            
            
            
            6.402012
      to 2013
            
            
            14,933
            
            
            
            6.41
            
            
            
            2,417
            
            
            
            6.35
            
            
            
            3,024
            
            
            
            7.01
            
            
            
            ---
            
            
            
            ---
            
            
            
            7,533
            
            
            
            8.02
            
            
            
            1,510
            
            
            
            7.85
            
            
            
            29,417
            
            
            
            6.952014
      to 2018
            
            
            10,490
            
            
            
            5.91
            
            
            
            13,740
            
            
            
            6.32
            
            
            
            10,540
            
            
            
            6.98
            
            
            
            ---
            
            
            
            ---
            
            
            
            5,784
            
            
            
            7.75
            
            
            
            1,799
            
            
            
            7.38
            
            
            
            42,353
            
            
            
            6.622019
      to 2023
            
            
            7,665
            
            
            
            6.24
            
            
            
            13,129
            
            
            
            7.33
            
            
            
            1,905
            
            
            
            6.61
            
            
            
            ---
            
            
            
            ---
            
            
            
            12,252
            
            
            
            8.93
            
            
            
            24
            
            
            
            7.38
            
            
            
            34,975
            
            
            
            7.612024
      and following
            
            
            34,359
            
            
            
            5.56
            
            
            
            14,672
            
            
            
            6.46
            
            
            
            2,331
            
            
            
            7.34
            
            
            
            ---
            
            
            
            ---
            
            
            
            9,932
            
            
            
            7.89
            
            
            
            352
            
            
            
            7.32
            
            
            
            61,646
            
            
            
            6.23Total
            
            $
            84,788
            
            
            
            5.75
            %
            
            $
            45,374
            
            
            
            6.68
            %
            
            $
            27,333
            
            
            
            7.05
            %
            
            $
            6,302
            
            
            
            7.92
            %
            
            $
            46,391
            
            
            
            8.19
            %
            
            $
            10,803
            
            
            
            8.18
            %
            
            $
            220,991
            
            
            
            6.80
            %




___________________________________________




(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, 2008, which have predetermined interest rates, is $147.5 million,
while the total amount of loans due after such date, which have floating or
adjustable interest rates is $53.0 million.










6










Lending
Authority.  The Senior Vice President – Lending Manager and our
Chief Executive Officer may approve unsecured consumer loans up to $200,000 and
$500,000, respectively, and up to $700,000 together.  They also may
approve secured consumer loans and residential mortgage and construction and
development loans up to $500,000 and $750,000, respectively and up to $1,250,000
together.  The Senior Vice President – Chief Credit Officer and our
Chief Executive Officer may approve unsecured commercial loans up to $500,000
alone or $1.0 million together and secured commercial loans up to $750,000 alone
or $1.5 million together.  Loans over these amounts or otherwise
outside our general underwriting guidelines must be approved by the entire board
of directors or a committee thereof.




At
December 31, 2007, the maximum amount under federal law that we could lend to
any one borrower and the borrower’s related entities was approximately $2.4
million.  Our five largest lending relationships are with commercial
borrowers and totaled $10.7 million in the aggregate, or 4.8% of our $221.0
million loan portfolio, at December 31, 2007.  The largest
relationship consists of $2.3 million in loans to an individual’s land
development company and on his leased commercial real estate and principal
residence; which are secured by the underlying real estate.  The next
four largest lending relationships at December 31, 2007, were $2.2 million to a
real estate company, which is secured by a 250-acre parcel of land being
developed for high-end residences; $2.1 million to an equipment leasing company,
which is secured by receivables; $2.1 million to an individual and four of his
businesses, which are secured by receivables, inventory and equipment and a
personal residence and $2.0 million to an individual’s land development company
and to that individual for his investment in that company, which is secured by
the underlying real estate.  All of these loans were current as of
December 31, 2007.  At December 31, 2007, we had no other lending
relationships that exceeded $2 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 are seeking
potential purchasers for loans currently in our portfolio that are not saleable
to Fannie Mae to increase these benefits to our operations.  From 2005
through 2007, our mortgage loan originations decreased primarily due to a
decrease in refinancing activity.  We are currently selling 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, 2007,
one- to four-family residential mortgage loans (including loans held for sale)
totaled $84.8 million, or 38.1%, of our gross loan portfolio, of which $66.3
million were fixed-rate loans and $18.5 million were adjustable rate
loans.




Substantially
all of the loans we retain in our portfolio consist of loans that are not
saleable to Fannie Mae.  We do not offer subprime loan
programs.  We do originate some Alt-A, stated income (no income
verification) and low-doc loans; however, we do not actively seek these types of
loans.  These Alt-A, stated income and low-doc loans generally are
originated with existing customers and are subject






7






to one or
more stringent underwriting criteria, including lower loan-to-value ratios,
lower debt-to-income ratios and higher required credit scores.  All
these loans are charged a higher rate of interest than the rate charged on loans
conforming to Fannie Mae guidelines, based on the additional credit
risk.




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 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, 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, 2007, we originated $30.6 million of one- to four-family
fixed-rate mortgage loans and $9.1 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 $147,000 at December 31,
2007.




Home Equity
Lending.  Our home equity
loans, consisting of fixed-rate loans and variable-rate lines of credit, have
been increasing in amount and as a percentage of our portfolio consistently over
the past several years.  At December 31, 2007, home equity lines of
credit totaled $27.6 million and home equity loans totaled $17.8 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






8






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, 2007, unfunded
commitments on these lines of credit totaled $20.0 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.




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, 2007, commercial real estate loans totaled
$27.3 million, or 12.4%, of our gross loan portfolio.




Our loans
secured by commercial real estate are generally originated with a fixed interest
rate 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 at prime plus 1% to 2% for another five years.  Loan-to-value
ratios on our commercial real estate loans typically do not exceed 80% of the
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 do not
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,
2007, totaled $2.3 million and is secured by land held for
development.  At December 31, 2007, 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, 2007, our construction and development loans totaled $8.6 million,
or 3.9%, of our gross loan portfolio.






9






Construction
loans to individuals and contractors for the construction and acquisition of
personal residences totaled $2.3 million, or 63.1%, of our construction and
development portfolio.  At December 31, 2007, the unadvanced portion
of these construction loans totaled $1.4 million.




Our
construction loans generally provide for the payment of interest only during the
construction phase, which is typically up to 12 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, 2007, our largest residential
construction mortgage loan commitment was for $600,000, $357,000 of which had
been disbursed.  This loan was performing according to its
terms.  The average outstanding residential construction loan balance
was approximately $145,000 at December 31, 2007.




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




We make
development loans to builders or residential lot developers.  These
loans involve a higher decree of credit risk similar to commercial construction
loans.  At December 31, 2007, we had a total of $6.3 million in
development loans to builders and residential lot developers, with our largest
development loan being a $2.3 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 two years under terms similar to our residential construction
loans.  We had no construction loans secured by commercial real estate
at December 31, 2007.




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.  Our involvement in
this type of lending increased significantly after 2004, because a large
financial institution in the area ceased making 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, 2007 was 8.69%, compared to 5.75% for one- to four-family
residential mortgages, including loans held for sale.  At December 31,
2007, these loans totaled $22.5 million, or 48.9% of our consumer loans and
10.2% 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






10






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 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, 2007, $37,000 or
0.16% of our manufactured home loans were non-performing.




We make
loans on new and used automobiles.  Our automobile loan portfolio
totaled $15.1 million at December 31, 2007, or 32.5% of our consumer loan
portfolio and 6.9% 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 120% 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, 2007, totaled $8.9 million, or 4.0% 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, 2007, unfunded
commitments on our unsecured lines of credit totaled $3.2 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 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).









11









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.




Commercial
Business Lending.  At December 31, 2007, commercial business
loans totaled $10.8 million, or 4.9%, of our gross loan
portfolio.  Our commercial business lending activities encompass loans
with a variety of purposes and security, including loans to finance commercial
vehicles and equipment.  Approximately $1.6 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 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 on August 29,
2007.  Demand is affected by competition and the interest rate
environment.






12






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.  We have not purchased loans or
loan participations recently, but we may do so in the future.




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




We also
sell whole residential real estate loans without recourse to Fannie Mae, subject
to a provision for repurchase upon breach of representation, warranty or
covenant.  These loans are fixed-rate mortgages, which primarily are
sold to improve our interest rate risk.  These loans are generally
sold for cash in amounts equal to the unpaid principal amount of the loans
determined using present value yields to the buyer.  These sales allow
for a servicing fee on loans when the servicing is retained by
us.  Most residential real estate loans sold by us are sold with
servicing retained.  We earned mortgage servicing income of $315,000,
$310,000 and $384,000, respectively, for the years ended December 31, 2007, 2006
and 2005.  At December 31, 2007, we were servicing a $132.8 million
portfolio of residential mortgage loans for Fannie Mae.  Those
servicing rights constituted an $865,000 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, 2007 was $1.2
million.  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.  The volume of loans sold in 2007 and 2006 decreased as
interest rates began to increase, reducing the volume of refinancing
activity.  We sold $25.7 million, $24.9 million and $37.1 million of
these loans during the years ended December 31, 2007, 2006 and 2005,
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 2007, 2006 and 2005 were
$11,000, ($10,000) and ($13,000), 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.  There were no loans purchased during these
periods.





For
      the year
              ended
      December 31,2007
            
            
            2006
            
            
            2005(In
      thousands)Originations
      by type:Fixed-rate:One-
      to four-family real estate
            
            $
            30,601
            
            
            $
            38,712
            
            
            $
            53,966Home
      equity
            
            
            5,768
            
            
            
            13,593
            
            
            
            4,742Commercial
      real estate
            
            
            10,391
            
            
            
            1,035
            
            
            
            7,482Construction
      and development
            
            
            2,531
            
            
            
            6,747
            
            
            
            6,773Consumer
            
            
            12,012
            
            
            
            19,191
            
            
            
            20,583Commercial
      business
            
            
            3,404
            
            
            
            1,669
            
            
            
            8,945Total
      fixed-rate
            
            
            64,707
            
            
            
            80,947
            
            
            
            102,491Adjustable
      rate:One- to four-family
      real estate(1)
            
            
            9,221
            
            
            
            6,982
            
            
            
            4,079Home
      equity
            
            
            11,301
            
            
            
            7,879
            
            
            
            13,394Commercial
      real estate
            
            
            5,081
            
            
            
            325
            
            
            
            ---Construction
      and development
            
            
            1,919
            
            
            
            1,748
            
            
            
            ---Consumer
            
            
            389
            
            
            
            191
            
            
            
            51Commercial
      business
            
            
            2,793
            
            
            
            769
            
            
            
            2,647Total
      adjustable-rate
            
            
            30,704
            
            
            
            17,894
            
            
            
            20,171Total
      loans originated
            
            
            95,411
            
            
            
            98,841
            
            
            
            122,662Sales
      and Repayments:One-
      to four-family real estate
            
            
            25,644
            
            
            
            26,221
            
            
            
            37,122Consumer
            
            
            ---
            
            
            
            11,602
            
            
            
            ---Total
      loans sold
            
            
            25,644
            
            
            
            37,823
            
            
            
            37,122Mortgage-backed
      securities
            
            
            ---
            
            
            
            ---
            
            
            
            2,670Total
      sales
            
            
            25,644
            
            
            
            37,823
            
            
            
            39,792Total
      principal repayments
            
            
            55,728
            
            
            
            46,106
            
            
            
            52,368Total
      reductions
            
            
            81,373
            
            
            
            83,929
            
            
            
            92,160Net
      increase (decrease)
            
            $
            14,038
            
            
            $
            14,912
            
            
            $
            30,502







(1)
            These
      loans include $3.4 million, $2.8 million, and $4.6 million, respectively,
      of adjustable rate mortgage loan originations to employees at December 31,
      2007, 2006 and 2005.





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 if past
due 180 days, 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, 2007.





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
            
            
            2
            
            
            $
            565
            
            
            
            0.67
            %
            
            
            1
            
            
            $
            256
            
            
            
            0.30
            %
            
            
            3
            
            
            $
            821
            
            
            
            0.98
            %Commercial
      Real Estate
            
            
            2
            
            
            
            396
            
            
            
            1.45
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            2
            
            
            
            396
            
            
            
            1.45Consumer
            
            
            21
            
            
            
            139
            
            
            
            0.30
            
            
            
            11
            
            
            
            162
            
            
            
            0.35
            
            
            
            32
            
            
            
            296
            
            
            
            0.64Total
            
            
            25
            
            
            $
            1,100
            
            
            
            0.50
            %
            
            
            12
            
            
            $
            418
            
            
            
            0.19
            %
            
            
            37
            
            
            $
            1,513
            
            
            
            0.69
            %








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.  The increase in one-to-four family non-accruals at June 30,
2007 is the result of late payments on one large mortgage.  For all
years presented, we had no 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).  Foreclosed assets include
assets acquired in settlement of loans, including two foreclosed properties
totaling $817,000.  The largest foreclosed property has a book value
of 601,000 as of December 31, 2007.  We do not expect to experience a
material loss on any of the foreclosed assets in our possession.








December
      31,2007
            
            
            2006
            
            
            2005
            
            
            2004
            
            
            2003(Dollars
      in thousands)Non-accruing
      loans:One-
      to four-family
            
            $
            256
            
            
            $
            132
            
            
            $
            ---
            
            
            $
            --
            
            
            $
            ---Home
      equity
            
            
            ---
            
            
            
            ---
            
            
            
            20
            
            
            
            ---
            
            
            
            ---Consumer
            
            
            162
            
            
            
            160
            
            
            
            109
            
            
            
            42
            
            
            
            65Total
            
            
            418
            
            
            
            292
            
            
            
            129
            
            
            
            42
            
            
            
            65Accruing
      loans delinquent more
              than
      90 days:One-
      to four-family
            
            
            ---
            
            
            
            ---
            
            
            
            129
            
            
            
            ---
            
            
            
            51Home
      equity
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            39Consumer
            
            
            ---
            
            
            
            ---
            
            
            
            191
            
            
            
            10
            
            
            
            89Commercial
      business
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            8Total
            
            
            ---
            
            
            
            ---
            
            
            
            320
            
            
            
            10
            
            
            
            187Foreclosed
      assets:One-
      to four-family
            
            
            817
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---Consumer
            
            
            35
            
            
            
            106
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---Total
            
            
            852
            
            
            
            106
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---Total
      non-performing assets
            
            $
            1,270
            
            
            $
            398
            
            
            $
            449
            
            
            $
            52
            
            
            $
            252Total
      as a percentage of total assets
            
            
            0.54
            %
            
            
            0.18
            %
            
            
            0.22
            %
            
            
            0.03
            %
            
            
            0.17
            %







For the
year ended December 31, 2007, gross interest income which would have been
recorded had the non-accruing loans been current in accordance with their
original terms amounted to $11,000, which was included in interest income for
the year ended December 31, 2007.




Other Loans of
Concern.  In addition to the non-performing assets set forth in
the table above, as of December 31, 2007, there were eight loans totaling
$748,000 with respect to which known information about the possible credit
problems of the borrowers have caused management to have doubts as to the
ability of the borrowers to comply with present loan repayment terms and which
may result in the future inclusion of such items in the non-performing asset
categories.  These loans have been considered in management’s
determination of our allowance for loan losses.  The largest loan
relationship of concern at December 31, 2007, totaled $330,000 in loans to an
individual borrower for a loan secured by their primary residence.




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








16








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 an
insured institution classifies problem assets as either substandard or doubtful,
it may establish general allowances for loan losses in an amount deemed prudent
by management.  General allowances represent loss allowances which
have been established to recognize the risk associated with lending activities,
but which, unlike specific allowances, have not been allocated to particular
problem assets.  When an insured institution classifies problem assets
as “loss,” it is required either to establish a specific allowance for losses
equal to 100% of that portion of the asset so classified or to charge off such
amount.  An institution’s determination as to the classification of
its assets and the amount of its 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, 2007, we had classified $852,000 of our assets as substandard, all
of which represented 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 5.3% of our equity capital and 0.4% of our assets at December 31,
2007.  Classified assets totaled $3.3 million, or 21.2% of our equity
capital and 1.5% of our assets at December 31, 2006.  Improvements in
our credit administration procedures during 2007 allowed us to reverse the
classification of a number of commercial loans during 2007, which contributed to
the decrease in classified assets from 2006 to 2007.




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, 2007, our allowance for loan losses was $828,000, or 0.37%, of our
total loan portfolio.  Our allowance in 2006 and 2007 was lower than
in 2005, because of lower losses on our loan portfolio during the periods,
higher net charge-offs and recoveries and the sale of our credit card portfolio
in June 2006.  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.  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.


17




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





December
      31,2007
            
            
            2006
            
            
            2005
            
            
            2004
            
            
            2003(Dollars
      in thousands)Balance
      at beginning of period
            
            $
            822
            
            
            $
            1,321
            
            
            $
            1,033
            
            
            $
            826
            
            
            $
            721Charge-offs:Consumer
            
            
            483
            
            
            
            1,013
            
            
            
            752
            
            
            
            741
            
            
            
            844Recoveries:Consumer
            
            
            239
            
            
            
            233
            
            
            
            94
            
            
            
            91
            
            
            
            24Net
      charge-offs
            
            
            244
            
            
            
            780
            
            
            
            658
            
            
            
            650
            
            
            
            820Additions
      charged to operations
            
            
            250
            
            
            
            281
            
            
            
            946
            
            
            
            857
            
            
            
            925Balance
      at end of period
            
            $
            828
            
            
            $
            822
            
            
            $
            1,321
            
            
            $
            1,033
            
            
            $
            826Ratio
      of net charge-offs during the
              period
      to average loans outstanding
              during
      the
      period
            
            
            0.11
            %
            
            
            0.40
            %
            
            
            0.37
            %
            
            
            0.45
            %
            
            
            0.68
            %Ratio
      of net charge-offs during the
              period
      to average non-performing
              assets
            
            
            33.46
            %
            
            
            184.42
            %
            
            
            262.67
            %
            
            
            427.63
            %
            
            
            163.35
            %Allowance
      as a percentage of
              non-performing
      loans
            
            
            198.22
            %
            
            
            281.51
            %
            
            
            294.21
            %
            
            
            1,986.54
            %
            
            
            327.78
            %Allowance
      as a percentage of total loans
              (end
      of
      period)
            
            
            0.37
            %
            
            
            0.40
            %
            
            
            0.69
            %
            
            
            0.65
            %
            
            
            0.62
            %







During June 2006, we sold our credit
card portfolio.  The credit card portfolio, and charge-offs and the
inherent risks associated with that portfolio, were the primary reasons for the
level of provisions taken during the years December 31, 2002 through
2006.  Net charge-offs for the credit card portfolio totaled $509,000
in 2006, $495,000 in 2005, $508,000 in 2004 and $607,000 in
2003.


18


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





2007
            
            
            2006
            
            
            2005
            
            
            2004
            
            
            2003Amount
            
            
            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
            
            $
            145
            
            
            
            38.37
            %
            
            $
            100
            
            
            
            41.60
            %
            
            $
            90
            
            
            
            39.84
            %
            
            $
            85
            
            
            
            42.55
            %
            
            $
            80
            
            
            
            49.22
            %Home
      equity
            
            
            100
            
            
            
            20.53
            
            
            
            40
            
            
            
            18.99
            
            
            
            35
            
            
            
            14.86
            
            
            
            30
            
            
            
            15.01
            
            
            
            30
            
            
            
            13.79Commercial
      real estate
            
            
            170
            
            
            
            11.32
            
            
            
            170
            
            
            
            8.46
            
            
            
            165
            
            
            
            8.10
            
            
            
            100
            
            
            
            9.47
            
            
            
            75
            
            
            
            8.55Construction
      or development
            
            
            25
            
            
            
            3.90
            
            
            
            30
            
            
            
            4.57
            
            
            
            20
            
            
            
            4.05
            
            
            
            20
            
            
            
            3.25
            
            
            
            20
            
            
            
            2.05Consumer(1)
            
            
            298
            
            
            
            20.99
            
            
            
            407
            
            
            
            22.71
            
            
            
            931
            
            
            
            27.84
            
            
            
            748
            
            
            
            26.84
            
            
            
            596
            
            
            
            24.44Commercial
      business
            
            
            90
            
            
            
            4.89
            
            
            
            75
            
            
            
            3.67
            
            
            
            80
            
            
            
            5.82
            
            
            
            50
            
            
            
            2.89
            
            
            
            25
            
            
            
            1.95Total
            
            $
            828
            
            
            
            100.00
            %
            
            $
            822
            
            
            
            100.00
            %
            
            $
            1,321
            
            
            
            100.00
            %
            
            $
            1,033
            
            
            
            100.00
            %
            
            $
            826
            
            
            
            100.00
            %









(1)
            Because
      of the sale of our credit card portfolio in June 2006, no portion of our
      allowance at December 31, 2007 or December 31, 2006 was allocated to
      credit card lending.  The allowance for loans losses
      attributable to our credit card portfolio at December 31, 2005, 2004 and
      2003 was $600,000, $518,000 and $450,000
  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.




Our
investment portfolio is a small portion of our assets because we attempt to be
fully invested in loans.  Sound Community Bank expects net proceeds
not used to repay Federal Home Loan Bank advances initially will be used to
invest in US Government and federal agency securities of various maturities,
mortgage-backed or other marketable securities, deposits in other financial
institutions, or a combination thereof, until they can be deployed in an orderly
fashion.  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 $1.3 million in stock of
the Federal Home Loan Bank of Seattle at December 31, 2007.  For the
year ended December 31, 2007, we received $8,000 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, 2007, 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
      31,2007
            
            
            2006
            
            
            2005
            
            
            2004Amortized
              Cost
            
            
            Fair
              Value
            
            
            Amortized
              Cost
            
            
            Fair
              Value
            
            
            Amortized
              Cost
            
            
            Fair
              Value
            
            
            Amortized
              Cost
            
            
            Fair
              Value(In
      thousands)Securities
      available for sale, at fair value:U.S. government and
      federal agency
            
            $
            ---
            
            
            $
            ---
            
            
            $
            ---
            
            
            $
            ---
            
            
            $
            ---
            
            
            $
            ---
            
            
            $
            1,534
            
            
            $
            1,489Mortgage-backed
            
            
            68
            
            
            
            71
            
            
            
            165
            
            
            
            170
            
            
            
            242
            
            
            
            222
            
            
            
            1,996
            
            
            
            1,982Other
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            10
            
            
            
            10Total
      available for sale
            
            
            68
            
            
            
            71
            
            
            
            165
            
            
            
            170
            
            
            
            242
            
            
            
            222
            
            
            
            3,540
            
            
            
            3,481Total
      investment securities
            
            
            68
            
            
            
            71
            
            
            
            165
            
            
            
            170
            
            
            
            242
            
            
            
            222
            
            
            
            3,540
            
            
            
            3,481Federal
      Home Loan Bank stock
            
            
            1,320
            
            
            
            1,320
            
            
            
            1,320
            
            
            
            1,320
            
            
            
            1,320
            
            
            
            1,320
            
            
            
            1,136
            
            
            
            1,136Total
      securities
            
            $
            1,388
            
            
            $
            1,391
            
            
            $
            1,485
            
            
            $
            1,490
            
            
            $
            1,562
            
            
            $
            1,542
            
            
            $
            4,676
            
            
            $
            4,617








The
composition and maturities of our investment securities portfolio at December
31, 2007, excluding Federal Home Loan Bank stock, are indicated in the following
table.






1
      year or less
            
            
            Over
      1 to 5 years
            
            
            Over
      5 to 10 years
            
            
            Over
      10 years
            
            
            Total
      securitiesAmortized
              Cost
            
            
            Weighted
                Average
                Yield
            
            
            Amortized
              Cost
            
            
            Weighted
                Average
                Yield
            
            
            Amortized
              Cost
            
            
            Weighted
                Average
                Yield
            
            
            Amortized
              Cost
            
            
            Weighted
                Average
                Yield
            
            
            Amortized
              Cost
            
            
            Weighted
                Average
                Yield
            
            
            Fair
              Value(Dollars
      in thousands)Securities
      available for sale, at fair
      value:Mortgage-backed
            
            $
            ---
            
            
            
            ---
            %
            
            $
            ---
            
            
            
            ---
            %
            
            $
            ---
            
            
            
            ---
            %
            
            $
            68
            
            
            
            8.00
            %
            
            $
            68
            
            
            
            8.00
            %
            
            $
            71









21





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, 2007, approximately 6.0% of our deposits were from persons
outside the State of Washington. At December 31, 2007,
we had no brokered, Internet or wholesale deposits.  We primarily rely
on competitive pricing policies, marketing and customer service to attract and
retain these deposits.  As of December 31, 2007, core deposits, which
we define as our non-certificate or non-time deposit accounts, represented
approximately 47.7% of total deposits.




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.  At December 31, 2007 approximately $10.2 million if the
increase in deposits was attributable to money being deposited with us to
purchase stock in or initial public offering which was completed on January 8,
2008.




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




For
      the year ended December 31,2007
            
            
            2006
            
            
            2005(Dollars
      in thousand)Opening
      balance
            
            $
            180,968
            
            
            $
            168,173
            
            
            $
            158,901Net
      deposits (withdrawals)
            
            
            15,245
            
            
            
            7,354
            
            
            
            5,535Interest
      credited
            
            
            6,578
            
            
            
            5,441
            
            
            
            3,737Ending
      balance
            
            $
            202,791
            
            
            $
            180,968
            
            
            $
            168,173Net
      increase
            
            $
            21,823
            
            
            $
            12,795
            
            
            $
            9,272Percent
      increase
            
            
            12.06
            %
            
            
            7.61
            %
            
            
            5.84
            %













22







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
      31,2007
            
            
            2006
            
            
            2005Amount
            
            
            Percent
              of
      total
            
            
            Amount
            
            
            Percent
              of
      total
            
            
            Amount
            
            
            Percent
              of
      total(Dollars
      in thousand)Transactions
      and Savings Deposits:Interest-bearing
      demand
            
            $
            31,999
            
            
            
            15.78
            %
            
            $
            12,711
            
            
            
            7.02
            %
            
            $
            9,194
            
            
            
            5.47
            %Non
      interest-bearing checking
            
            
            13,290
            
            
            
            6.55
            
            
            
            17,251
            
            
            
            9.53
            
            
            
            15,557
            
            
            
            9.25Statement
      savings
            
            
            11,696
            
            
            
            5.77
            
            
            
            12,510
            
            
            
            6.91
            
            
            
            16,848
            
            
            
            10.02Money
      market
            
            
            39,754
            
            
            
            19.60
            
            
            
            53,270
            
            
            
            29.44
            
            
            
            54,431
            
            
            
            32.37Total
      non-certificates
            
            
            96,739
            
            
            
            47.70
            
            
            
            95,742
            
            
            
            52.91
            
            
            
            96,030
            
            
            
            57.10Certificates:0.00
      - 0.99%
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            104
            
            
            
            0.061.00
      - 3.99%
            
            
            6,339
            
            
            
            3.13
            
            
            
            16,519
            
            
            
            9.13
            
            
            
            46,461
            
            
            
            27.634.00
      - 5.99%
            
            
            99,708
            
            
            
            49.17
            
            
            
            68,549
            
            
            
            37.87
            
            
            
            25,227
            
            
            
            15.006.00
      - 7.99%
            
            
            5
            
            
            
            0.00
            
            
            
            155
            
            
            
            0.09
            
            
            
            345
            
            
            
            0.218.00%
      and over
            
            
            ---
            
            
            
            ---
            
            
            
            3
            
            
            
            0.00
            
            
            
            6
            
            
            
            ---Total
      certificates
            
            
            106,052
            
            
            
            52.30
            
            
            
            85,226
            
            
            
            47.08
            
            
            
            72,143
            
            
            
            42.90Total
      deposits
            
            $
            202,791
            
            
            
            100.00
            %
            
            $
            180,968
            
            
            
            100.00
            %
            
            $
            168,173
            
            
            
            100.00
            %







Recent increases in certificate
accounts reflect recent increases in general market rates, which have made our
customers more willing to commit their funds for a specified
time.  Our plans for 2008 are to attract money market savings and
demand or checking accounts.  We require our commercial loan customers
to maintain a demand 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 but have not received any public funds
deposits.  We do not expect that we will receive a large amount of
these public funds due to the strong competition for such funds.





23








The
following table shows rate and maturity information for the Bank’s certificates
of deposit at December 31, 2007.








1.00-
      3.99
            %
            
            
            4.00-
      5.99
            %
            
            6.00-
              or
      greater
            
            
            Total
            
            
            Percent
              of
      Total(Dollars
      in thousands)Certificate
      accounts
              maturing
      in quarter ending:March
      31,
      2008
            
            $
            2,124
            
            
            $
            13,490
            
            
            $
            ---
            
            
            $
            15,614
            
            
            
            14.72
            %June
      30,
      2008
            
            
            1,014
            
            
            
            34,081
            
            
            
            ---
            
            
            
            35,095
            
            
            
            33.09September
      30, 2008
            
            
            1,044
            
            
            
            10,257
            
            
            
            ---
            
            
            
            11,301
            
            
            
            10.66December
      31, 2008
            
            
            699
            
            
            
            14,781
            
            
            
            ---
            
            
            
            15,480
            
            
            
            14.60March
      31,
      2009
            
            
            722
            
            
            
            4,204
            
            
            
            ---
            
            
            
            4,926
            
            
            
            4.64June
      30,
      2009
            
            
            389
            
            
            
            3,542
            
            
            
            ---
            
            
            
            3,931
            
            
            
            3.71September
      30, 2009
            
            
            4
            
            
            
            2,198
            
            
            
            ---
            
            
            
            2,202
            
            
            
            2.08December
      31, 2009
            
            
            ---
            
            
            
            9,186
            
            
            
            ---
            
            
            
            9,186
            
            
            
            8.66March
      31,
      2010
            
            
            5
            
            
            
            1,606
            
            
            
            ---
            
            
            
            1,611
            
            
            
            1.52June
      30,
      2010
            
            
            26
            
            
            
            1,046
            
            
            
            ---
            
            
            
            1,072
            
            
            
            1.01September
      30, 2010
            
            
            1
            
            
            
            1,204
            
            
            
            2
            
            
            
            1,207
            
            
            
            1.14December
      31, 2010
            
            
            171
            
            
            
            616
            
            
            
            3
            
            
            
            790
            
            
            
            0.74Thereafter
            
            
            140
            
            
            
            3,497
            
            
            
            ---
            
            
            
            3,637
            
            
            
            3.43Total
            
            $
            6,339
            
            
            $
            99,708
            
            
            $
            5
            
            
            $
            106,052
            
            
            
            100.00
            %Percent
      of
      total
            
            
            5.98
            %
            
            
            94.02
            %
            
            
            ---
            
            
            
            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, 2007.








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
            
            $
            8,809
            
            
            $
            18,928
            
            
            $
            12,783
            
            
            $
            15,237
            
            
            $
            55,757Certificates
      of deposit of $100,000 or more
            
            
            6,803
            
            
            
            16,168
            
            
            
            13,999
            
            
            
            13,325
            
            
            
            50,295Total
      certificates of deposit
            
            $
            15,612
            
            
            $
            35,096
            
            
            $
            26,782
            
            
            $
            28,562
            
            
            $
            106,052










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






24








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.  Sound Community Bank has entered into a
loan agreement with the Federal Home Loan Bank of Seattle pursuant to which it
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,
2007, we had $15.9 million in Federal Home Loan Bank advances outstanding, which
had maturities between one and two years, and had the ability to borrow an
additional $31.6 million.  At the same date, we had $84.0 million in
residential mortgages 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 are required to own stock in the Federal Home Loan Bank of
Seattle based on the amount of our advances.  At December 31, 2007, we
had $1.3 million of FHLB Stock.




Sound
Community 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 31,2007
            
            
            2006
            
            
            2005(Dollars
      in thousands)Maximum
      balance:Federal
      Home Loan Bank advances
            
            $
            34,519
            
            
            $
            24,485
            
            
            $
            25,399Average
      balances:Federal
      Home Loan Bank advances
            
            $
            26,511
            
            
            $
            19,824
            
            
            $
            16,239Weighted
      average interest rate:Federal
      Home Loan Bank advances
            
            
            5.08
            %
            
            
            4.77
            %
            
            
            3.93
            %








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








December
      31,2007
            
            
            2006
            
            
            2005(Dollars
      in thousands)Federal
      Home Loan Bank advances
            
            $
            15,869
            
            
            $
            22,029
            
            
            $
            21,304Weighted
      average interest rate of:Federal
      Home Loan Bank advances
            
            
            4.63
            %
            
            
            4.84
            %
            
            
            4.29
            %









25






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 $4.8 million at December 31, 2007, 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, 2007 was $2,400.




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
bankers.  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.  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 Washington
Mutual, Countrywide, 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, Sound Community 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 71.3% of those
deposits.  In addition, our share of deposits in Clallam County was
4.6%, with the five largest institutions in that county having 68.5% of the
deposits.




Employees




At
December 31, 2007, we had a total of 63 full-time employees and 10 part-time
employees.  Our employees are not represented by any collective
bargaining group.  Management considers its employee relations to be
good.  For the last three years, we have been selected by Washington CEO
Magazine as one of the 50 best employers in the Seattle
area.




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.






26








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 on August 29, 2007.




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, 2007, the Bank
met this requirement with a qualified thrift lender percentage of
73.01%.




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






27








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, 2007, the Bank’s lending limit
under this restriction was $2.4 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.




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, 2007 were $100,000.  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.




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.






28








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, 2007, the Bank had
tangible capital of $15.9 million or 6.70% 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, 2007, the Bank had
core capital equal to $16.0 million or 6.70% 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, 2007, consisted of $828,000 of its allowance for possible loan and
lease losses and a $3,000 unrealized gain on securities available for
sale.  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, 2007, the Bank had $159 million of
risk-weighted assets and total capital of $16.7 million or 10.5% of
risk-weighted assets.




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




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






29








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% leverage capital ratio, a 6.0% Tier 1
risked-based capital ratio and an 10.0% total risk-based capital
ratio.  At December 31, 2007, 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.




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.







30






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,
2007.




The
Company recognizes interest accrued and penalties related to unrecognized tax
benefits in tax expense.  During the years ended December 31, 2007 and 2006
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, 2007, 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.




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






31






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






























32


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, 2007.  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, 2007, 2006 and 2005 was $538,000, $582,000 and $481,000,
respectively.  The aggregate net book value of the Company’s leasehold
improvements, furniture and equipment was $1.4 million at December 31,
2007.  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 last quarter of 2008, though a specific location has
not been selected.  We may open additional banking offices after 2008
to better serve current customers and to attract new customers.





Location
            
            Year
      opened
            
            Owned orleased
            
            Leaseexpiration
      dateMain
      office:2005
      5th
      Avenue
              Seattle,
      WA 98121
            
            1993
            
            Leased
            
            
            2017
            1Branch
      offices:Cedar
      Plaza Branch
              22807
      44th
      Avenue West
              Mountlake
      Terrace, WA 98043
            
            2004
            
            Leased
            
            
            2015
            2East
      Marginal Branch(Tukwila)
              10200
      East Marginal Way South
              Seattle,
      WA 98168
            
            1953
            
            Leased
            
            
            2010
            3Lakewood
      Branch
              Lakewood
      Town  Center
              61111
      Lakewood Town Center
              Blvd.,
      SW, Suite B
              Lakewood,
      WA 98499
            
            2004
            
            Leased
            
            
            2009
            4Sequim
      Branch
              541
      North 5th
      Avenue
              Sequim,
      WA 98382
            
            1997
            
            Leased
            
            
            2013
            5


_________________




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. The book value of all
data processing and computer equipment utilized by Sound Community Bank at
December 31, 2007 was $257,000.  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.






33








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




No matter
was submitted to a vote of security holders, through the solicitation of proxies
or otherwise, during the quarter ended December 31, 2007.








PART
II




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




We had no common stock outstanding in
2007 and 2006.  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.  Except for the original issuance price of $10.00 per
share, our stock price reflects the high and low bid information for each
period.  The closing price of our common stock on March 24, 2008 was
$9.14.  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.  The shares of Sound
Financial are traded on the Over-the-Counter Electronic Bulletin Board under the
symbol "SNFL.OB."





The board of directors of Sound
Financial, Inc. currently intends to pay cash dividends on the common stock in
the future.  The amount and timing of any dividends, however, has not
yet been determined.  The payment of dividends 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.





We have no equity compensation plans
and have not repurchased any shares of our Common Stock.


34




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 31,2007
            
            
            2006
            
            
            2005(In
      thousands)Selected
      Financial Condition Data:Total
      assets
            
            $
            236,965
            
            
            $
            220,663
            
            
            $
            204,231Loans
      receivable, net
            
            
            219,406
            
            
            
            204,812
            
            
            
            189,466Loans
      held for sale
            
            
            822
            
            
            
            1,307
            
            
            
            1,069Mortgage-backed
      securities available for sale (at fair value)
            
            
            71
            
            
            
            170
            
            
            
            222Federal
      Home Loan Bank stock
            
            
            1,320
            
            
            
            1,320
            
            
            
            1,320Deposits
            
            
            202,791
            
            
            
            180,968
            
            
            
            168,173Federal
      Home Loan Bank advances
            
            
            15,869
            
            
            
            22,029
            
            
            
            21,304Equity
            
            
            15,888
            
            
            
            15,569
            
            
            
            13,310






For
      the year ended
                December
      31,2007
            
            
            2006
            
            
            2005(In
      thousands)Selected
      Operations Data:Total
      interest income
            
            $
            14,959
            
            
            $
            13,641
            
            
            $
            12,158Total
      interest expense
            
            
            7,925
            
            
            
            6,386
            
            
            
            4,376Net interest
      income
            
            
            7,034
            
            
            
            7,255
            
            
            
            7,782Provision
      for loan losses
            
            
            250
            
            
            
            282
            
            
            
            946Net interest income
      after provision for loan losses
            
            
            6,784
            
            
            
            6,973
            
            
            
            6,836Fees
      and service charges
            
            
            1,633
            
            
            
            1,911
            
            
            
            1,642Gain (loss) on sales
      of loans(1)
            
            
            11
            
            
            
            2,277
            
            
            
            (13
            )Gain
      (loss) on sales of securities
            
            
            ---
            
            
            
            ---
            
            
            
            (21
            )Other
      non-interest income
            
            
            472
            
            
            
            424
            
            
            
            508Total non-interest
      income
            
            
            2,116
            
            
            
            4,612
            
            
            
            2,116Total
      non-interest expense
            
            
            8,519
            
            
            
            8,234
            
            
            
            8,298Income
      before provision for income taxes
            
            
            381
            
            
            
            3,351
            
            
            
            654Provision
      for income taxes
            
            
            62
            
            
            
            1,108
            
            
            
            258Net
      income
            
            $
            319
            
            
            $
            2,243
            
            
            $
            396


_____________________________




(1)
            The
      gain on sale of loans for the year ended December 31, 2006 and for the six
      months ended June 30, 2006, includes the $2.3 million gain on the sale of
      our $11.6 million credit card
portfolio.


35







For
      the year endedDecember
      31,2007
            
            
            2006
            
            
            2005Selected
      Financial Ratios and Other Data:Performance
      ratios:(1)Return on assets
      (ratio of net income to average total assets)
            
            
            0.14
            %
            
            
            1.06
            %
            
            
            0.21
            %Return on equity
      (ratio of net income to average equity)
            
            
            2.00
            %
            
            
            15.10
            %
            
            
            2.93
            %Interest rate spread
      information:Average during
      period
            
            
            3.11
            %
            
            
            3.53
            %
            
            
            4.28
            %End of
      period
            
            
            3.19
            %
            
            
            3.02
            %
            
            
            3.68
            %Net interest
      margin(2)
            
            
            3.22
            %
            
            
            3.64
            %
            
            
            4.33
            %Non-interest income
      to operating revenue
            
            
            23.12
            %
            
            
            39.81
            %
            
            
            23.64
            %Operating expense to
      average total assets
            
            
            3.70
            %
            
            
            3.90
            %
            
            
            4.34
            %Average
      interest-earning assets to average interest-bearing
      liabilities
            
            
            99.79
            %
            
            
            103.34
            %
            
            
            102.42
            %Efficiency
      ratio(3)
            
            
            93.10
            %
            
            
            69.39
            %
            
            
            83.66
            %Asset
      quality ratios:Non-performing
      assets to total assets at end of period
            
            
            0.54
            %
            
            
            0.18
            %
            
            
            0.22
            %Non-performing loans
      to gross loans
            
            
            0.19
            %
            
            
            0.14
            %
            
            
            0.23
            %Allowance for loan
      losses to non-performing loans
            
            
            198.22
            %
            
            
            281.51
            %
            
            
            294.21
            %Allowance for loan
      losses to gross loans
            
            
            0.37
            %
            
            
            0.40
            %
            
            
            0.69
            %Net charge-offs to
      average loans outstanding
            
            
            0.11
            %
            
            
            0.40
            %
            
            
            0.37
            %Capital
      ratios:Equity to total
      assets at end of period
            
            
            6.70
            %
            
            
            7.06
            %
            
            
            6.52
            %Average equity to
      average assets
            
            
            6.94
            %
            
            
            7.03
            %
            
            
            7.07
            %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.










36




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, its name was 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 $882,000 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 $2,934,000 for working capital.  As the MHC
reorganization and stock offering were completed subsequent to the year ended
December 31, 2007, the information in this document relates primarily to the
bank, except as otherwise indicated.




Our
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 loans and,
to a lesser extent, construction and development loans and commercial business
loans.  We offer a wide variety of secured and unsecured consumer loan
products, including manufactured home loans, direct automobile loans, and boat
and recreational vehicle loans.  We intend to continue emphasizing our
residential mortgage, home equity and consumer lending, while also expanding our
emphasis in the commercial real estate, construction and development and
commercial business lending areas.  In recent years, we have focused
on expanding our commercial and construction and development lending; however,
our commercial lending has been limited by our capital level and, until
recently, an OTS supervisory directive that restricted our commercial loan
portfolios to levels specified in our business plan submitted when we applied
for a savings bank charter.




The OTS
issued a supervisory directive to the Bank in November 2005, because its capital
was below levels in its business plan, its level of commercial real estate and
business loans was above levels in its business plan, its earnings were below
levels to maintain adequate capital; it did not conduct an independent loan
review; and its commercial loan monitoring required
improvement.  Under that directive, as amended, the 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.  The Bank also was required to reach earnings and capital
levels in their business plan and enhance their loan review and classification
process, including obtaining an independent loan review.  The
directive affected our operations by limiting our total investment in commercial
loans; however, it was terminated on August 29, 2007.






37






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 $30.6 million and $38.7 million in
fixed-rate one- to four-family residential mortgage loans during the years ended
December 31, 2007 and 2006, respectively.  During these same periods,
we sold $25.7 million and $26.2 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, however, we have relied
increasingly on Federal Home Loan Bank advances to augment our deposits and fund
our loan growth.  We have adopted a leverage strategy to use long-term
Federal Home Loan Bank advances to fund asset and loan growth.  We
have adopted a plan of reorganization and stock issuance, primarily to increase
our capital to grow our loan portfolio and to continue to build our
franchise.




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.




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 from sales of
loans, commission income, other income, operating expenses and income
taxes.




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 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






38






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, the OTS, as
an integral part of its examination process, periodically reviews our allowance
for loan losses.  Such agency 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 $865,000 as of December 31, 2007.  If our mortgage servicing
rights were determined to be impaired, our financial results would be
impacted.




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.






39








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 will 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 will 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 will 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 2008, 2009
and 2010.  Our next branch is expected to be located in Clallam
County, though no specific location has been selected.  No locations
have been selected for additional future branch expansions.




Emphasizing lower
cost core deposits to reduce the funding costs of our loan
growth.   We offer personal and business checking
accounts, NOW accounts and savings and money market accounts, which generally
are lower-cost sources of funds than certificates of deposits, and are less
sensitive to withdrawal when interest rates fluctuate. In order to build our
core deposit base, we are pursuing a number of strategies.  First, we
will 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 checking account.




Growing and
diversifying our loan portfolio by emphasizing the origination of one- to
four-family residential mortgage, home equity, commercial real estate,
commercial business, construction and development, 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 and construction and development 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.  The addition of our Chief Credit
Officer strengthens our ability to increase our commercial loan products, while
maintaining asset quality.  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.    Our asset quality has improved in
recent years, through managing credit risk, and is reflected by our low level of
nonperforming assets.  Our percentage of non-performing assets to
total assets was 0.54% and 0.18% at December 31, 2007 and December 31, 2006,
respectively.  The increase in 2007 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






40






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.




Comparison
of Financial Condition at December 31, 2007 and December 31, 2006




General.  Total assets
increased by $16.3 million, or 7.4%, to $237.0 million at December 31, 2007 from
$220.7 million at December 31, 2006.  The increase was primarily the
result of a $14.9 million, or 7.2%, increase in our loan portfolio, including
loans held for sale, from $206.1 million at December 31, 2006, to $221.0 million
at December 31, 2007.  The increase in total assets was funded by a
$21.8 million increase in deposits, which was offset by a $6.2 million decrease
in Federal Home Loan Bank advances.




Loans.  Our
loan portfolio, including loans held for sale, increased $14.9 million, or 7.2%,
from $206.1 million at December 31, 2006 to $221.0 million at December 31,
2007.  This increase in our loan portfolio consisted primarily of a
$10.0 million (48.3%) increase in commercial real estate loans, a $6.1 million
(15.5%) increase in home equity loans, a $2.7 million (13.7%) increase in
manufactured home loans and a $3.2 million (42.1%) increase in commercial
business loans, which was offset by a $6.0 million (6.3%) decrease in
residential mortgage loans, including loans held for sale and a $3.3 million
(12.0%) decrease in consumer loans.  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 decline in our residential loan portfolio is primarily
the result of the general slow down of housing purchases in our market
area.  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.  Despite the overall slowdown in the national housing
market and the pressures of the sub-prime market failures, the housing and
employment markets remain strong in the Puget Sound area.  As a result
of the decrease in residential loan originations, loans held for sale decreased
$500,000, or 37.1%, from $1.3 million at December 31, 2006, to $822,000 at
December 31, 2007.




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.  We






41






use
historical peer group averages for commercial loans, due to the less-seasoned
nature of this portion of our loan portfolio.  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, 2007 was $828,000 or 0.37% of net
loans receivable, compared to $822,000 or 0.40% of net loans receivable at
December 31, 2006.  The increase in the allowance for loan losses was
due primarily to net charge-offs of non-performing loans of $244,000, offset by
a provision for loan losses of $250,000 during the year ended December 31,
2007.  This provision was made during the last half of 2007 as a
result of a small increases in our delinquencies and non-performing loans, a
slowdown in the local residential housing market and increases in our commercial
loan portfolios.  Non-performing loans increased from $292,000 at
December 31, 2006 to $418,000 at December 31, 2007, primarily as a result of one
non-performing first mortgage loan, which made up $256,000 or 61.2% of our
non-performing loans at the end of 2007.  Non-performing loans to
total loans increased from 0.14% at December 31, 2006 to 0.19% at December 31,
2007.  Our loan portfolio includes a small amount of Alt-A , low-doc
and stated income loans.  We 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.




Deposits.  Total
deposits increased by $21.8 million, or 12.1%, to $202.8 million at December 31,
2007 from $181.0 million at December 31, 2006.  During 2007, time
deposits increased $20.8 million and demand deposits and interest-bearing
checking accounts increased $15.3 million, while savings and money market
accounts decreased $14.3 million.  Total deposits increased as a
result of $10.2 million deposited by investors in connection with our stock
offering, which was not closed until January 2008. We also had success in
growing commercial deposit accounts.  The increase in time deposits
and the decrease in money market and savings accounts was primarily the result
of depositors transferring funds between these accounts to achieve higher rates
offered by us in time deposit specials at higher than market rates.




Borrowings.  Federal
Home Loan Bank advances decreased $6.2 million, or 28.0%, to $15.9 million at
December 31, 2007 from $22.0 million at December 31, 2006.  This
reduction was primarily to higher-cost, short-term borrowings. We rely on
Federal Home Loan Bank advances to fund loan growth, when deposit growth is
insufficient to fund loan growth.  This reliance on borrowings, rather
than deposits, has typically increased our overall cost of funds.




Equity.  Total
equity increased $319,000, or 2.0%, to $16.0 million at December 31, 2007 from
$15.6 million at December 31, 2006, primarily as a result of net earnings of
$319,000 in 2007.




42


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 31,2007
              
              
              2006
              
              
              2005Average
                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)
              
              $
              216,076
              
              
              $
              14,911
              
              
              
              6.90
              %
              
              $
              197,535
              
              
              $
              13,534
              
              
              
              6.85
              %
              
              $
              177,769
              
              
              $
              12,070
              
              
              
              6.79
              %Mortgage-backed
      securities(2)
              
              
              118
              
              
              
              11
              
              
              
              9.32
              
              
              
              197
              
              
              
              (24
              )
              
              
              (12.16
              )
              
              
              362
              
              
              
              (18
              )
              
              
              (4.97
              )Other
              
              
              1,432
              
              
              
              37
              
              
              
              2.58
              
              
              
              1,579
              
              
              
              131
              
              
              
              8.29
              
              
              
              1,462
              
              
              
              106
              
              
              
              7.25Total
      interest-earning assets(1)
              
              
              217,626
              
              
              
              14,959
              
              
              
              6.87
              
              
              
              199,311
              
              
              
              13,641
              
              
              
              6.84
              
              
              
              179,593
              
              
              
              12,158
              
              
              
              6.77Interest-Bearing
      Liabilities:Savings
      and Money Markets
              
              
              56,512
              
              
              
              1,642
              
              
              
              2.91
              
              
              
              68,267
              
              
              
              2,077
              
              
              
              3.04
              
              
              
              65,859
              
              
              
              1,275
              
              
              
              1.94Demand
      and NOW accounts
              
              
              32,727
              
              
              
              288
              
              
              
              0.88
              
              
              
              24,928
              
              
              
              29
              
              
              
              0.12
              
              
              
              23,723
              
              
              
              26
              
              
              
              0.11Certificate
      accounts
              
              
              96,648
              
              
              
              4,649
              
              
              
              4.81
              
              
              
              79,747
              
              
              
              3,335
              
              
              
              4.18
              
              
              
              69,489
              
              
              
              2,436
              
              
              
              3.50Borrowings
              
              
              26,511
              
              
              
              1,346
              
              
              
              5.08
              
              
              
              19,824
              
              
              
              945
              
              
              
              4.77
              
              
              
              16,239
              
              
              
              639
              
              
              
              3.93Total
      interest-bearing liabilities
              
              
              212,398
              
              
              
              7,925
              
              
              
              3.73
              
              
              
              192,766
              
              
              
              6,386
              
              
              
              3.31
              
              
              
              175,310
              
              
              
              4,376
              
              
              
              2.50Net
      interest income
              
              
              
              
              
              $
              7,034
              
              
              
              
              
              
              
              
              
              
              $
              7,255
              
              
              
              
              
              
              
              
              
              
              $
              7,782Net
      interest rate spread
              
              
              
              
              
              
              
              
              
              
              3.14
              %
              
              
              
              
              
              
              
              
              
              
              3.53
              %
              
              
              
              
              
              
              
              
              
              
              4.27
              %Net
      earning assets
              
              $
              5,228
              
              
              
              
              
              
              
              
              
              
              $
              6,545
              
              
              
              
              
              
              
              
              
              
              $
              4,283Net
      interest margin
              
              
              
              
              
              
              
              
              
              
              3.23
              %
              
              
              
              
              
              
              
              
              
              
              3.64
              %
              
              
              
              
              
              
              
              
              
              
              4.33
              %Average
      interest-earning assets to
                average
      interest-bearing liabilities
              
              
              
              
              
              
              102.46
              %
              
              
              
              
              
              
              103.40
              %
              
              
              
              
              
              
              
              
              
              
              102.44
              %


______________________________________





(1)
            Calculated
      net of deferred loan fees, loan discounts, loans in process and loss
      reserves.(2)
            The
      negative yields during 2006 and 2005 are the result of the acceleration of
      the amortization of premiums caused by significant prepayments during the
      periods.





43





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,
                2007
      vs. 2006
              
              
              Year
      ended December 31,
                2006
      vs. 2005Increase
                (decrease)
      due to
              
              
              Total
                increase
              
              
              Increase
                (decrease)
      due to
              
              
              Total
                increaseVolume
              
              
              Rate
              
              
              (decrease)
              
              
              Volume
              
              
              Rate
              
              
              (decrease)(In
      thousands)Interest-earning
      assets:Loans
      receivable
              
              $
              1,274
              
              
              $
              103
              
              
              $
              1,377
              
              
              $
              1,342
              
              
              $
              122
              
              
              $
              1,464Mortgage-backed
      securities
              
              
              (5
              )
              
              
              40
              
              
              
              35
              
              
              
              9
              
              
              
              (14
              )
              
              
              (5
              )Other
              
              
              (4
              )
              
              
              (90
              )
              
              
              (94
              )
              
              
              9
              
              
              
              15
              
              
              
              24Total interest-earning assets
              
              $
              1,265
              
              
              $
              53
              
              
              $
              1,318
              
              
              $
              1,360
              
              
              $
              123
              
              
              $
              1,483Interest-bearing
      liabilities:Savings
      and Money Market
              
              $
              (354
              )
              
              $
              (81
              )
              
              $
              (435
              )
              
              $
              47
              
              
              $
              755
              
              
              $
              802Demand
      and NOW accounts
              
              
              40
              
              
              
              219
              
              
              
              259
              
              
              
              1
              
              
              
              2
              
              
              
              3Certificate
      accounts
              
              
              758
              
              
              
              556
              
              
              
              1,314
              
              
              
              359
              
              
              
              541
              
              
              
              900Borrowings
              
              
              329
              
              
              
              72
              
              
              
              401
              
              
              
              141
              
              
              
              165
              
              
              
              306Total interest-bearing liabilities
              
              $
              774
              
              
              $
              765
              
              
              
              1,539
              
              
              $
              548
              
              
              $
              1,463
              
              
              
              2,011Net
      interest income (loss)
              
              
              
              
              
              
              
              
              
              $
              (221
              )
              
              
              
              
              
              
              
              
              
              $
              (528
              )





44


Comparison
of Results of Operation for the Year Ended December 31, 2007 and
2006




General.  Net
income decreased $1.9 million to $319,000 for the year ended December 31, 2007
from $2.2 million for the year ended December 31, 2006.  The primary
reason for this decrease was our June 2006 sale of our existing credit card
portfolio to a third-party provider for credit card services at a gain of $2.3
million (pre-tax).  Netting out the credit card gain in 2006, net
income was $702,000 compared to $319,000 in 2007.  The main factors
related to this decrease was related to interchange income earned from VISA in
2006 but not in 2007, as well as lower net interest income as a result of the
VISA sale and higher cost of funds resulting from higher prevailing market
rates.




Interest
Income.  Interest income increased by $1.3 million, or 9.7%, to
$15.0 million for the year ended December 31, 2007 from $13.6 million for the
year ended December 31, 2006.  The increase in interest income was
primarily related to the increased volume of loans outstanding during the
period.




The
weighted average yield on loans increased from 6.85% for the year ended December
31, 2006 to 6.90% for the year ended December 31, 2007.  The increase
was primarily the result of higher prevailing market interest rates in 2007 than
in 2006.  We anticipate our weighted average yield on loans will
improve as we continue to emphasize higher yielding commercial real estate and
commercial business lending.




Interest
Expense.  Interest expense increased $1.5 million, or 24.1%, to
$7.9 million for the year ended December 31, 2007, from $6.4 million for the
year ended December 31, 2006.  The increase in interest expense was
primarily due to the increased levels of time deposits and Federal Home Loan
Bank advances, and the higher interest rates paid on those funds as a result of
the rising interest rate environment.  Our weighted average cost of
interest-bearing liabilities was 3.73% for the year ended December 31, 2007
compared to 3.31% for the same time period in 2006.




Interest
paid on deposits increased $1.1 million, or 20.1%, to $6.6 million for the year
ended December 31, 2007, as compared to $5.4 million for the year ended December
31, 2006.  The increase resulted primarily from an increase in the
average balance of outstanding time deposits of $16.9 million to $96.6 million
during the year ended December 31, 2007, compared to $79.7 million during the
year ended December 31, 2006.  A 63 basis point increase in the
average rate paid on those funds also contributed to the
increase.  Partially offsetting the increase was a $11.8 million
decrease in the average balance of outstanding savings and money market accounts
during the year ended December 31, 2007, compared to the year ended December 31,
2006.




Interest
expense on Federal Home Loan Bank advances increased $401,000, or 42.4%, to $1.3
million for the year ended December 31, 2007 from $945,000 for the year ended
December 31, 2006.  The increase resulted from an increase in the
average balance of outstanding Federal Home Loan Bank advances of $6.7 million,
to $26.5 million for the year ended December 31, 2007 from $19.8 million for the
year ended December 31, 2006.  In addition, the cost of Federal Home
Loan Bank advances increased 31 basis points from 4.77% for the 2006 period to
5.08% for the 2007 period.




Net Interest
Income.  Net interest income decreased $221,000, or 3.0%, to
$7.0 million for the year ended December 31, 2007 from $7.3 million for the year
ended December 31, 2006.  The decrease in net interest income
primarily resulted from an increase in our cost of funds caused by the continued
rising interest rate environment.  The increase in our cost of funds
was greater than the increase in our average yield on loans.  Our net
interest margin was 3.22% for the year ended December 31, 2007, compared to
3.64% for the year ended December 31, 2006.






45








Provision for
Loan Losses.  We establish provisions for loan losses, which
are charged to earnings, at a level required to reflect 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.  Larger
non-homogeneous loans, such as commercial 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.




Based on
management’s evaluation of these factors, provisions of $250,000 and $282,000
were made during the years ended December 31, 2007 and 2006,
respectively.  The decrease in the provision for loan losses for 2007
was primarily attributable to the sale of the higher risk credit card portfolio
in June 2006 and the current level of the allowance for loan
losses.  At December 31, 2007, the annualized ratio of net charge-offs
to average loans decreased 3 basis points to 0.37% from 0.40% at December 31,
2006.  The ratio of non-performing loans to total loans increased from
0.14% at December 31, 2006 to 0.19% at December 31, 2007, primarily due to the
addition of one non-performing first mortgage loan.




Noninterest
Income.  Noninterest income decreased $2.5 million, or 54.1%,
to $2.1 million for the year ended December 31, 2007 from $4.6 million for the
year ended December 31, 2006.  The overall decrease is the result of
the $2.3 million one-time gain resulting from the sale of the credit card
portfolio in June 2006.  Fees and services charges decreased $278,000
or 14.6% during the 2007 period to $1.6 million, primarily because of a
reduction in VISA credit card interchange income during the 2007
period.




Noninterest
Expense.  Noninterest expense increased $284,000, or 3.4%, to
$8.5 million for the year ended December 31, 2007, compared to $8.2 million for
the year ended December 31, 2006.  The increase was primarily the
result of higher data processing expense in 2007 compared to
2006.  The increase in data processing expense was offset to an extent
by a decrease in operations expense related to VISA credit card
processing.




Income Tax
Expense.For the periods ended December 31, 2007 and 2006,
there was a $1.0 million decrease in tax expense, due to the gain on the sale of
our credit card portfolio, from $1.1 million in 2006, to $62,000 in
2007.




Liquidity




Management
maintains a liquidity position that it believes will adequately provide funding
for loan demand and deposit run-off that may occur in the normal course of
business.  We rely on a number of different sources in order to meet
our potential liquidity demands.  The primary sources are increases in
deposit accounts, Federal Home Loan Bank advances and cash flows from loan
payments.




As of
December 31, 2007, our total borrowing capacity was $47.4 million with the
Federal Home Loan Bank of Seattle, subject to certain requirements, with unused
borrowing capacity of $31.6 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.  In order to obtain an additional source of
liquidity, we have been in discussions with an institutional investor to
determine if it will purchase our mortgage products that do not meet Fannie Mae
standards, including land loans, jumbo loans, and some adjustable rate mortgage
loans.  Because of a recent tightening of






46






credit
funding generally and reduction in institutional investors investing in
securitized mortgage products, it is not certain this arrangement will be
finalized




Liquidity
management is both a daily and long-term function of business
management.  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.  Participation loans sold include commercial real estate
loans.  These participations are sold to manage borrower concentration
risk as well as interest rate risk.  This activity has increased as a
result of increased production.  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, 2007, the approved outstanding
loan commitments, including unused lines of credit, amounted to $37.7
million.  Certificates of deposit scheduled to mature in one year or
less at December 31, 2007, totaled $77.5 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 Sound Community
Bank.




During
2007, cash and cash equivalents increased $456,000, or 8.1%, from $5.6 million
as of December 31, 2006 to $6.1 million as of December 31, 2007.  Cash
from financing activities of $15.7 million and cash from operating activities of
$3.8 million more than offset cash used for investing activities of $19.0
million for the year ended December 31, 2007.  Primary sources of cash
for 2007 included an increase in deposits of $21.8 million.  Primary
uses of cash included an increase in net loans receivable and loans held for
sale of $14.1 million.




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




Off-Balance
Sheet Activities




In the normal course of operations,
Sound Community 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, 2007, 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, 2007, is as follows:




Off-balance sheet loan
      commitments:Commitments
      to make loans
            
            $
            1,406Undisbursed
      portion of loans closed
            
            
            2,324Unused
      lines of
      credit
            
            
            32,354Irrevocable
      letters of
      credit
            
            
            1,575Total
      loan
      commitments
            
            $
            37,659





47


Capital
Resources




Sound
Community Bank is subject to minimum capital requirements imposed by the
OTS.  Based on its capital levels at December 31, 2007, Sound
Community 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 Sound
Community Bank to maintain a “well-capitalized” status under the capital
categories of the OTS.  Based on capital levels at December 31, 2007,
Sound Community Bank was considered to be
well-capitalized.  Management monitors the capital levels of Sound
Community 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,
2007.




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)
            
            $
            15,885
            
            
            
            6.70
            %
            
            $
            9,479
            
            
            
            4.00
            %
            
            
            11,848
            
            
            
            5.00
            %Core
      capital (to risk-weighted assets)
            
            $
            15,885
            
            
            
            10.00
            %
            
            $
            9,572
            
            
            
            6.00
            %(1)
            
            
            9,531
            
            
            
            6.00
            %Risked-based capital (to risk-weighted assets)
            
            $
            16,716
            
            
            
            10.52
            %
            
            $
            12,708
            
            
            
            8.00
            %
            
            
            15,885
            
            
            
            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.”




After
December 31, 2007, the Bank became a subsidiary of the Company, and the Company
raised $13.0 million in its public offering, which resulted in net proceeds of
$12.1 million, which increased the capital levels of the Company and the
Bank.  We believe that we have sufficient capital to carry out our
proposed business plan at least through 2008 and to meet any applicable
regulatory capital requirements during that period.




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 Sound Community 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.




48


Recent
Accounting Pronouncements




In
September 2006, the Financial Accounting Standards Board (“FASB”) released
Statement No. 157, Fair Value Measurements (“SFAS 157”), which defines fair
value, establishes a framework for measuring fair value in GAAP, and enhances
disclosures about fair value measurements.  SFAS 157 applies when
other accounting pronouncements require fair value measurements; it does not
require new fair value measurements.  SFAS 157 is effective for
financial statements issued for fiscal years beginning after November 15, 2007,
and interim periods within those years.  We estimate that the initial
application of SFAS 157 will not be material.





In
February 2007, the FASB issued Statement No. 159, The Fair Value Option for Financial
Assets and Financial Liabilities—Including an amendment of FASB Statement
No. 115(“SFAS 159”).  SFAS 159 permits the choice of
measuring financial instruments and certain other items at fair
value.  SFAS 159 is effective for financial statements issued for
fiscal years beginning after November 15, 2007. We have elected not to
apply the provisions of SFAS 159 to our eligible financial assets and
financial liabilities on the date of adoption. Accordingly, the initial
application of SFAS 159 will have no effect on our financial
statements.





In
December 2007, the FASB issued Statement No. 141(R), Business Combinations(“SFAS
141(R)”).  SFAS 141(R) establishes principles and requirements for how
an acquirer recognizes and measures in its financial statements the identifiable
assets acquired, the liabilities assumed, and any noncontrolling interest in the
acquiree and recognizes and measures the goodwill acquired in the business
combination or a gain from a bargain purchase. SFAS 141(R) also sets forth
the disclosures required to be made in the financial statements to evaluate the
nature and financial effects of the business combination. SFAS 141(R) applies
prospectively to business combinations for which the acquisition date is on or
after the beginning of the first annual reporting period beginning on or after
December 15, 2008.  Accordingly, we will apply SFAS 141(R)
to business combinations occurring on or after January 1,
2009.





In
December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in
Consolidated Financial Statements, an amendment of ARB No. 51 (“SFAS
160”).  SFAS 160 establishes accounting and reporting standards
that require that the ownership interests in subsidiaries held by parties other
than the parent be clearly identified, labeled, and presented in the
consolidated statement of financial position within equity, but separate from
the parent’s equity; the amount of consolidated net income attributable to the
parent and to the noncontrolling interest be clearly identified and presented on
the face of the consolidated statement of income; and changes in a parent’s
ownership interest while the parent retains its controlling financial interest
in its subsidiary be accounted for consistently.





SFAS 160
also requires that any retained noncontrolling equity investment in the former
subsidiary be initially measured at fair value when a subsidiary is
deconsolidated. SFAS 160 also sets forth the disclosure requirements to
identify and distinguish between the interests of the parent and the interests
of the noncontrolling owners. SFAS 160 applies to all entities that prepare
consolidated financial statements, except not-for-profit organizations, but will
affect only those entities that have an outstanding noncontrolling interest in
one or more subsidiaries or that deconsolidate a subsidiary. SFAS 160 is
effective for fiscal years, and interim periods within those fiscal years,
beginning on or after December 15, 2008. Earlier adoption is prohibited.
SFAS 160 must be applied prospectively as of the beginning of the fiscal
year in which SFAS 160 is initially applied, except for the presentation
and disclosure requirements. The presentation and disclosure requirements are
applied retrospectively for all periods presented.  We do not have a
noncontrolling interest in one or more subsidiaries. Accordingly, we do not
anticipate that the initial application of SFAS 160 will have an impact on
our financial statements.









49




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.




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






50






Sound
Community 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, 2007, except in the case of a 200 basis point increase in
rates.




The table
presented below, as of December 31, 2007 (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 200 basis points.




As
illustrated in the tables below, Sound Community 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.




December
      31, 2007Change
      in
              Interest
              Rates
      in
            
            
            Net
      Portfolio Value
            
            
            NPVBasis
      Points
            
            
            $
      Amount
            
            
            $
      Change
            
            
            %
      Change
            
            
            Ratio
      %(Dollars
      in thousands)300
            bp
            
            $
            15,073
            
            
            $
            (6,232
            )
            
            
            (29
            )%
            
            
            6.44
            %200
            bp
            
            
            17,357
            
            
            
            (3,948
            )
            
            
            (19
            )%
            
            
            7.31
            %100
            bp
            
            
            19,417
            
            
            
            (1,887
            )
            
            
            (9
            )%
            
            
            8.07
            %0
            bp
            
            
            21,305
            
            
            
            ---
            
            
            
            ---
            
            
            
            8.74
            %(100
            )bp
            
            
            23,162
            
            
            
            1,857
            
            
            
            9
            %
            
            
            9.39
            %(200
            )bp
            
            
            24,682
            
            
            
            3,377
            
            
            
            16
            %
            
            
            9.89
            %




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


51




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

























52







Item
8.           Financial
Statements and Supplementary Data







REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM








To the
Board of Directors


Sound
Community Bank and Subsidiary








We have
audited the accompanying consolidated balance sheets of Sound Community Bank and
Subsidiary (the Bank) as of December 31, 2007 and 2006, and the related
consolidated statements of income, equity, and cash flows for the two years then
ended. These consolidated financial statements are the responsibility of the
Bank’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 Bank 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 Bank’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 Community
Bank and Subsidiary as of December 31, 2007 and 2006, 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 31,
2008















53


SOUND
COMMUNITY BANK AND SUBSIDIARY


CONSOLIDATED
BALANCE SHEETS











ASSETS





DECEMBER
      31,2007
            
            
            2006CASH
      AND CASH EQUIVALENTS
            
            $
            6,104,963
            
            
            $
            5,649,306SECURITIES
      AVAILABLE-FOR-SALE, at fair value
            
            
            71,245
            
            
            
            169,569FEDERAL
      HOME LOAN BANK (FHLB) STOCK, at cost
            
            
            1,319,500
            
            
            
            1,319,500LOANS
      HELD-FOR-SALE
            
            
            822,129
            
            
            
            1,307,320LOANS
            
            
            220,233,447
            
            
            
            205,634,456Less
      allowance for loan losses
            
            
            (827,688
            )
            
            
            (822,393
            )Loans,
      net
            
            
            219,405,759
            
            
            
            204,812,063ACCRUED
      INTEREST RECEIVABLE
            
            
            1,051,476
            
            
            
            895,382PREMISES
      AND EQUIPMENT, net
            
            
            1,404,853
            
            
            
            1,330,199CASH
      SURRENDER VALUE OF BANK OWNEDLIFE
      INSURANCE
            
            
            4,035,412
            
            
            
            3,278,581MORTGAGE
      SERVICING RIGHTS
            
            
            864,946
            
            
            
            867,562OTHER
      REAL ESTATE OWNED
            
            
            817,108
            
            
            
            -OTHER
      ASSETS
            
            
            1,068,008
            
            
            
            1,033,363Total
      assets
            
            $
            236,965,399
            
            
            $
            220,662,845





See accompanying notes.
 54


SOUND
COMMUNITY BANK AND SUBSIDIARY


CONSOLIDATED
BALANCE SHEETS











LIABILITIES
AND EQUITY





DECEMBER
      31,2007
            
            
            2006DEPOSITSInterest-bearing
            
            $
            189,501,253
            
            
            $
            163,717,118Noninterest-bearing
      demand
            
            
            13,289,946
            
            
            
            17,250,876Total
      deposits
            
            
            202,791,199
            
            
            
            180,967,994FHLB
      ADVANCES
            
            
            15,869,355
            
            
            
            22,029,355ACCRUED
      INTEREST PAYABLE
            
            
            210,518
            
            
            
            121,561ACCOUNTS
      PAYABLE AND OTHER LIABILITIES
            
            
            1,951,786
            
            
            
            1,717,551ADVANCE
      PAYMENTS FROM BORROWERS FORTAXES
      AND INSURANCE
            
            
            254,213
            
            
            
            257,309Total
      liabilities
            
            
            221,077,071
            
            
            
            205,093,770COMMITMENTS
      AND CONTINGENTLIABILITIES
      (See Note 14)EQUITYRetained
      earnings
            
            
            15,885,167
            
            
            
            15,566,031Accumulated
      other comprehensive income
            
            
            3,161
            
            
            
            3,044Total
      equity
            
            
            15,888,328
            
            
            
            15,569,075Total
      liabilities and equity
            
            $
            236,965,399
            
            
            $
            220,662,845





See accompanying notes.
 55


SOUND
COMMUNITY BANK AND SUBSIDIARY


CONSOLIDATED
STATEMENT OF INCOME











YEARS
      ENDED DECEMBER 31,2007
            
            
            2006INTEREST
      INCOMELoans,
      including fees
            
            $
            14,910,648
            
            
            $
            13,533,830Interest
      and dividends on investments and cash equivalents
            
            
            47,987
            
            
            
            107,155Total
      interest income
            
            
            14,958,635
            
            
            
            13,640,985INTEREST
      EXPENSEDeposits
            
            
            6,578,434
            
            
            
            5,441,074FHLB
      advances
            
            
            1,346,127
            
            
            
            945,142Total
      interest expense
            
            
            7,924,561
            
            
            
            6,386,216NET
      INTEREST INCOME
            
            
            7,034,074
            
            
            
            7,254,769PROVISION
      FOR LOAN LOSSES
            
            
            250,000
            
            
            
            281,924NET
      INTEREST INCOME AFTER PROVISIONFOR
      LOAN LOSSES
            
            
            6,784,074
            
            
            
            6,972,845NONINTEREST
      INCOMEService
      charges and fee income
            
            
            1,632,957
            
            
            
            1,911,205Earnings
      on cash surrender value of bank ownedlife
      insurance
            
            
            156,831
            
            
            
            113,688Mortgage
      servicing income
            
            
            314,765
            
            
            
            310,126Gain
      on sale of credit card portfolio
            
            
            -
            
            
            
            2,287,309Gain
      (loss) on sale of loans
            
            
            10,949
            
            
            
            (10,168
            )Total
      noninterest income
            
            
            2,115,502
            
            
            
            4,612,160NONINTEREST
      EXPENSESalaries
      and benefits
            
            
            4,088,474
            
            
            
            4,039,693Operations
            
            
            2,389,294
            
            
            
            2,660,590Occupancy
            
            
            932,324
            
            
            
            694,115Data
      processing
            
            
            1,108,362
            
            
            
            839,893Total
      noninterest expense
            
            
            8,518,453
            
            
            
            8,234,291INCOME
      BEFORE PROVISION FOR INCOME TAXES
            
            
            381,122
            
            
            
            3,350,714PROVISION
      FOR INCOME TAXES
            
            
            61,986
            
            
            
            1,107,868NET
      INCOME
            
            $
            319,136
            
            
            $
            2,242,846





See accompanying notes.
 56


SOUND
COMMUNITY BANK AND SUBSIDIARY


CONSOLIDATED
STATEMENT OFEQUITY











AccumulatedOtherRetained
            
            
            Comprehensive
            
            
            Total
            
            
            ComprehensiveEarnings
            
            
            Income
      (Loss)
            
            
            Equity
            
            
            IncomeBALANCE,
      December 31, 2005
            
            $
            13,323,185
            
            
            $
            (13,438
            )
            
            $
            13,309,747
            
            
            $
            -Net
      income
            
            
            2,242,846
            
            
            
            -
            
            
            
            2,242,846
            
            
            
            2,242,846Unrealized
      gain on available-for-sale
      securities, net of tax
            
            
            -
            
            
            
            16,482
            
            
            
            16,482
            
            
            
            16,482BALANCE,
      December 31, 2006
            
            
            15,566,031
            
            
            
            3,044
            
            
            
            15,569,075
            
            
            
            2,259,328Net
      income
            
            
            319,136
            
            
            
            
            
            
            
            319,136
            
            
            
            319,136Unrealized
      gain on available-for-sale
      securities, net of tax
            
            
            -
            
            
            
            117
            
            
            
            117
            
            
            
            117BALANCE,
      December 31, 2007
            
            $
            15,888,167
            
            
            $
            3,161
            
            
            $
            15,888,328
            
            
            $
            319,253





See accompanying notes.
 57


SOUND
COMMUNITY BANK AND SUBSIDIARY


CONSOLIDATED
STATEMENT OF CASH FLOWS








YEARS
      ENDED DECEMBER 31,2007
            
            
            2006CASH
      FLOWS FROM OPERATING ACTIVITIESNet
      income
            
            $
            319,136
            
            
            $
            2,242,846Adjustments
      to reconcile net income to net cash from operating
    activitiesAmortization
      of net premium on investments
            
            
            3,544
            
            
            
            30,422Provision
      for loan losses
            
            
            250,000
            
            
            
            281,924Depreciation
      and amortization
            
            
            331,551
            
            
            
            367,666Additions
      to mortgage servicing rights
            
            
            (247,481
            )
            
            
            (296,823
            )Amortization
      of mortgage servicing rights
            
            
            250,097
            
            
            
            283,905Earnings
      on cash surrender value of bank owned life insurance
            
            
            (156,831
            )
            
            
            (113,688
            )Deferred
      income tax
            
            
            (93,000
            )
            
            
            712,000Gain
      on sale of credit card portfolio
            
            
            -
            
            
            
            (2,287,309
            )Proceeds
      from sales of mortgage loans
            
            
            25,643,933
            
            
            
            24,951,283Originations
      of mortgage loans held-for-sale
            
            
            (22,728,821
            )
            
            
            (24,955,222
            )(Gain)
      Loss on sale of loans
            
            
            (10,949
            )
            
            
            10,168Increase
      (decrease) in operating assets and liabilitiesChange
      in accrued interest receivable
            
            
            (156,094
            )
            
            
            (19,224
            )Change
      in other assets
            
            
            58,355
            
            
            
            (672,260
            )Change
      in accrued interest payable
            
            
            88,957
            
            
            
            37,886Change
      in accounts payable and other liabilities
            
            
            234,235
            
            
            
            194,396Net
      cash from operating activities
            
            
            3,786,632
            
            
            
            767,970CASH
      FLOWS FROM INVESTING ACTIVITIESProceeds
      from maturities of available-for-sale investments
            
            
            94,897
            
            
            
            46,719Purchase
      of bank owned life insurance
            
            
            (600,000
            )
            
            
            -Proceeds
      from sale of credit card portfolio
            
            
            -
            
            
            
            13,889,554Net
      increase in loans
            
            
            (18,079,776
            )
            
            
            (27,474,806
            )Purchases
      of premises and equipment
            
            
            (406,205
            )
            
            
            (126,049
            )Net
      cash from investing activities
            
            
            (18,991,084
            )
            
            
            (13,664,582
            )CASH
      FLOWS FROM FINANCING ACTIVITIESNet
      increase in deposits
            
            
            21,823,205
            
            
            
            12,795,379Net
      change in FHLB advances
            
            
            (6,160,000
            )
            
            
            725,000Net
      change in advances from borrowers for taxes and insurance
            
            
            (3,096
            )
            
            
            11,642Net
      cash from financing activities
            
            
            15,660,109
            
            
            
            13,532,021INCREASE
      (DECREASE) IN CASH AND CASH EQUIVALENTS
            
            
            455,657
            
            
            
            635,409CASH
      AND CASH EQUIVALENTS, beginning of year
            
            
            5,649,306
            
            
            
            5,013,897CASH
      AND CASH EQUIVALENTS, end of year
            
            $
            6,104,963
            
            
            $
            5,649,306SUPPLEMENTAL
      CASH FLOW INFORMATIONCash
      paid for income taxes
            
            $
            120,000
            
            
            $
            570,000Interest
      paid
            
            $
            7,835,604
            
            
            $
            6,348,330Transfer
      to other real estate owned
            
            $
            817,108
            
            
            $
            -





See accompanying notes.
 58






Note
1 - Organization and Summary of Significant Accounting Policies


Organization and principles of
consolidation - 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.




Subsequent event (Plan of
Reorganization) - 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, $3 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 $882,000 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 $2,934,000 for working
capital.  As the MHC reorganization and stock offering were completed
subsequent to the year ended December 31, 2007, the information in this document
relates primarily to the bank, except as otherwise indicated.




Capital
raising costs were deferred and deducted from the proceeds of the shares sold in
the offering. At December 31, 2007, $735,000 had been paid and
deferred.




59




Note
1 - Organization and Summary of Significant Accounting Policies
(continued)




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.




Cash and cash equivalents -
Cash and cash equivalents consist of cash on hand, demand deposits, and
interest-bearing deposits with banks, all of which mature within three months or
less. The Bank maintains its cash in depository institution accounts that, at
times, may exceed federally insured limits. The Bank has not experienced any
losses in such accounts.




Securities available-for-sale
- Securities available-for-sale consist of debt securities that the Bank has the
intent and ability to hold for an indefinite period, but not necessarily to
maturity. Such securities may be sold to implement the Bank’s asset/liability
management strategies and in response to changes in interest rates and similar
factors. Securities available-for-sale are reported at fair value. Unrealized
gains and losses, net of the related deferred tax effect, are reported as a net
amount in a separate component of equity entitled “accumulated other
comprehensive income (loss).” Realized gains and losses on securities
available-for-sale, determined using the specific identification method, are
included in earnings.




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.




Federal Home Loan Bank stock -
The Bank, as a member of the Federal Home Loan Bank (FHLB) system, is required
to maintain an investment in capital stock of the FHLB in an amount equal to the
greater of 1% of its outstanding home loans or 5% of advances from the FHLB. The
recorded amount of FHLB stock equals its fair value because the shares can only
be redeemed by the FHLB at the $100 per share par value. Stock redemptions are
at the discretion of the FHLB.




60






Note
1 - Organization and Summary of Significant Accounting Policies
(continued)




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. 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 180 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.




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.




61






Note
1 - Organization and Summary of Significant Accounting Policies
(continued)




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.




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 net realizable value. Net unrealized
losses, if any, are recognized through a valuation allowance by charges to
income.




62




Note
1 - Organization and Summary of Significant Accounting Policies
(continued)




Mortgage
loans held-for-sale are generally sold with the mortgage servicing rights
retained by the Bank. Gains or losses on sales of mortgage loans are recognized
based on the difference between the selling price and the carrying value of the
related mortgage loans sold.




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.




Foreclosed properties – Other
real estate properties and other personal property acquired through, or in lieu
of, foreclosure or repossession are to be sold and are initially recorded at the
lower of cost or fair value of the properties less estimated costs of disposal.
Any write-down to fair value at the time of transfer to foreclosed properties is
charged to the allowance for credit losses. Properties are evaluated regularly
to ensure that the recorded amounts are supported by their current fair values.
Any subsequent reductions in carrying values and revenue and expense from the
operations of properties are charged to noninterest income.




Deposits – At December 31,
2007 and 2006, deposits represent various accounts of the owners of the Bank
(see subsequent event footnote above). 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.




63




Note
1 - Organization and Summary of Significant Accounting Policies
(continued)




Income taxes - Income taxes
are provided for the tax effects of the transactions reported in the financial
statements and consist of taxes currently payable plus deferred taxes. Deferred
tax assets and liabilities result from differences between the financial
statement carrying amounts and the tax bases of assets and liabilities, 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 liability method. The deferred tax
provision represents the difference between the net deferred tax asset/liability
at the beginning and end of the year. As changes in tax laws or rates are
enacted, deferred tax assets and liabilities are adjusted through the provision
for income taxes.




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
$187,000 for each of the years ended December 31, 2007 and 2006.




64




Note
1 - Organization and Summary of Significant Accounting Policies
(continued)




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:




2007
            
            
            2006Unrealized
      holding gain on available-for-sale
      securities
            
            $
            117
            
            
            $
            24,972Reclassification
      adjustment for lossesrealized
      in income
            
            
            -
            
            
            
            -Net
      unrealized gains
            
            
            117
            
            
            
            24,972Tax
      effect
            
            
            -
            
            
            
            (8,490
            )Net-of-tax
      amount
            
            $
            117
            
            
            $
            16,482







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




2007
            
            
            2006Net
      unrealized gain (loss) onavailable-for-sale
      securities
            
            $
            3,161
            
            
            $
            4,612Tax
      effect
            
            
            -
            
            
            
            (1,568
            )Net-of-tax
      amount
            
            $
            3,161
            
            
            $
            3,044








Recently
Issued or Proposed Accounting Pronouncements




In
September 2006, the Financial Accounting Standards Board (“FASB”) released
Statement No. 157, Fair Value Measurements (“SFAS 157”), which defines fair
value, establishes a framework for measuring fair value in GAAP, and enhances
disclosures about fair value measurements.  SFAS 157 applies when
other accounting pronouncements require fair value measurements; it does not
require new fair value measurements.  SFAS 157 is effective for
financial statements issued for fiscal years beginning after November 15, 2007,
and interim periods within those years.  We estimate that the initial
application of SFAS 157 will not be material.






65






Note
1: Summary of Significant Accounting Policies (continued)




In
February 2007, the FASB issued Statement No. 159, The Fair Value Option for
Financial Assets and Financial Liabilities—Including an amendment of FASB
Statement No. 115 (“SFAS 159”).  SFAS 159 permits the choice
of measuring financial instruments and certain other items at fair
value.  SFAS 159 is effective for financial statements issued for
fiscal years beginning after November 15, 2007. We have elected not to
apply the provisions of SFAS 159 to our eligible financial assets and
financial liabilities on the date of adoption. Accordingly, the initial
application of SFAS 159 will have no effect on our financial
statements.




In
December 2007, the FASB issued Statement No. 141(R), Business Combinations
(“SFAS 141(R)”).  SFAS 141(R) establishes principles and requirements
for how an acquirer recognizes and measures in its financial statements the
identifiable assets acquired, the liabilities assumed, and any noncontrolling
interest in the acquiree and recognizes and measures the goodwill acquired in
the business combination or a gain from a bargain purchase. SFAS 141(R)
also sets forth the disclosures required to be made in the financial statements
to evaluate the nature and financial effects of the business combination. SFAS
141(R) applies prospectively to business combinations for which the acquisition
date is on or after the beginning of the first annual reporting period beginning
on or after December 15, 2008.  Accordingly, we will apply
SFAS 141(R) to business combinations occurring on or after January 1,
2009.




In
December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in
Consolidated Financial Statements, an amendment of ARB No. 51 (“SFAS
160”).  SFAS 160 establishes accounting and reporting standards
that require that the ownership interests in subsidiaries held by parties other
than the parent be clearly identified, labeled, and presented in the
consolidated statement of financial position within equity, but separate from
the parent’s equity; the amount of consolidated net income attributable to the
parent and to the noncontrolling interest be clearly identified and presented on
the face of the consolidated statement of income; and changes in a parent’s
ownership interest while the parent retains its controlling financial interest
in its subsidiary be accounted for consistently.




66




Note
1: Summary of Significant Accounting Policies (continued)




SFAS 160
also requires that any retained noncontrolling equity investment in the former
subsidiary be initially measured at fair value when a subsidiary is
deconsolidated. SFAS 160 also sets forth the disclosure requirements to
identify and distinguish between the interests of the parent and the interests
of the noncontrolling owners. SFAS 160 applies to all entities that prepare
consolidated financial statements, except not-for-profit organizations, but will
affect only those entities that have an outstanding noncontrolling interest in
one or more subsidiaries or that deconsolidate a subsidiary. SFAS 160 is
effective for fiscal years, and interim periods within those fiscal years,
beginning on or after December 15, 2008. Earlier adoption is prohibited.
SFAS 160 must be applied prospectively as of the beginning of the fiscal
year in which SFAS 160 is initially applied, except for the presentation
and disclosure requirements. The presentation and disclosure requirements are
applied retrospectively for all periods presented.  We do not have a
noncontrolling interest in one or more subsidiaries. Accordingly, we do not
anticipate that the initial application of SFAS 160 will have a material
impact on our financial statements.




Note
2 - Restrictions on Cash




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, 2007 and 2006.




At
December 31, 2007 and 2006, $83,350 and $226,500, respectively, of
interest-bearing deposits at other financial institutions were restricted as
part of the Bank’s contract with its credit card service provider.




Note
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, 2007Mortgage-backed
      securities
            
            $
            68,084
            
            
            $
            3,161
            
            
            $
            -
            
            
            $
            -
            
            
            $
            71,245December
      31, 2006Mortgage-backed
      securities
            
            $
            164,957
            
            
            $
            4,612
            
            
            $
            -
            
            
            $
            -
            
            
            $
            169,569





67




Note
3 – Investments (continued)




At
December 31, 2007, there are no investment securities with unrealized
losses.




The two
investments at December 31, 2007 are mortgage-backed securities with contractual
maturities in 2032. Expected maturities of mortgage-backed securities may differ
from contractual maturities because borrowers may have the right to call or
prepay the obligations.




There
were no securities sold for the years ending December 31, 2007 and 2006,
respectively.




There
were no securities pledged at December 31, 2007 and December 31,
2006.




Note
4 - Loans




The
composition of the loan portfolio was as follows:




2007
            
            
            2006Real
      estate loansOne-
      to four-family
            
            $
            83,965,522
            
            
            $
            84,793,680Home
      equity
            
            
            45,373,749
            
            
            
            39,302,296Commercial
            
            
            25,013,481
            
            
            
            17,501,332Construction
      or development
            
            
            8,621,743
            
            
            
            9,459,038162,974,495
            
            
            
            151,056,346Consumer
      loansManufactured
      homes
            
            
            22,495,034
            
            
            
            19,785,274Automobile
            
            
            15,077,564
            
            
            
            17,272,000Other
            
            
            8,818,012
            
            
            
            9,931,90546,390,610
            
            
            
            46,989,179Commercial
      business loans
            
            
            10,802,911
            
            
            
            7,600,362220,168,016
            
            
            
            205,645,887Deferred
      loan origination (fees) costs
            
            
            65,431
            
            
            
            (11,431
            )Allowance
      for loan losses
            
            
            (827,688
            )
            
            
            (822,393
            )Total
      loans, net
            
            $
            219,405,759
            
            
            $
            204,812,063





68




Note
4 – Loans (continued)




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




2007
            
            
            2006Balance,
      beginning of year
            
            $
            822,393
            
            
            $
            1,321,061Provision
      for loan losses
            
            
            250,000
            
            
            
            281,924Loans
      charged off
            
            
            (483,760
            )
            
            
            (1,013,374
            )Recoveries
            
            
            239,055
            
            
            
            232,782Balance,
      end of year
            
            $
            827,688
            
            
            $
            822,393





There are
no impaired loans at December 31, 2007 and 2006. At December 31, 2007, there
were no commitments to lend additional funds to borrowers whose loans have been
modified. Nonperforming loan information was as follows:




2007
            
            
            2006Nonaccrual
      loans
            
            $
            418,000
            
            
            $
            292,000Loans
      90 or more days past due andstill
      accruing interest
            
            
            -
            
            
            
            -$
            418,000
            
            
            $
            292,000





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, 2007 and 2006 totaled approximately $5,448,000 and $4,434,000,
respectively. During 2007, loan advances and repayments totaled approximately
$2,665,000 and $1,651,000 respectively, on these loans. During 2006, loan
advances and repayments totaled approximately $882,000 and $376,415,
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, 2007 and 2006
approximated $0 and $12,000,000, respectively.




69




Note
5 - Loan Servicing




The
unpaid principal balances of loans serviced for Federal National Mortgage
Association (FNMA) at December 31, 2007 and 2006 totaled approximately
$132,829,000 and $123,588,000, 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:




2007
            
            
            2006Balance,
      beginning of year
            
            $
            867,562
            
            
            $
            854,644Servicing
      assets recognized during the year
            
            
            247,481
            
            
            
            296,823Amortization
      of servicing assets
            
            
            (250,097
            )
            
            
            (283,905
            )Balance,
      end of year
            
            $
            864,946
            
            
            $
            867,562





There was
no valuation allowance for mortgage servicing rights at December 31, 2007 and
2006. The fair value of mortgage servicing rights was $1,248,590 and $1,137,012
at December 31, 2007 and 2006, respectively.




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




Prepayment
      speed (PSA)
            
            
            217
            %
            
            
            213
            %Weighted-average
      life (years)
            
            
            5.1
            
            
            
            5.1Yield
      to maturity discount rate
            
            
            10.0
            %
            
            
            10.0
            %







Note
6 - Premises and Equipment




Premises
and equipment are summarized as follows:




Leasehold
      improvements
            
            $
            1,552,684
            
            
            $
            1,505,332Furniture
      and equipment
            
            
            1,670,571
            
            
            
            1,296,6993,223,255
            
            
            
            2,802,031Accumulated
      depreciation and amortization
            
            
            (1,818,402
            )
            
            
            (1,482,915
            )1,404,853
            
            
            
            1,319,116Fixed
      assets in process
            
            
            -
            
            
            
            11,083$
            1,404,853
            
            
            $
            1,330,199





Depreciation
and amortization expense for the years ended December 31, 2007 and 2006 amounted
to $331,551 and $367,666, respectively.






70







Note
6 - Premises and Equipment (continued)




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 noncancelable operating leases with initial or remaining
terms of one year or more are as follows:




YEAR
      ENDINGDECEMBER
      31,
            
            AMOUNT2008
            
            $
            543,4282009
            
            
            541,6672010
            
            
            461,7852011
            
            
            450,3102012
            
            
            464,342Thereafter
            
            
            1,847,359$
            4,308,891





The total
rental expense for the years ended December 31, 2007 and 2006 for all
facilities leased under operating leases was approximately $538,000 and
$582,000, respectively.






Note
7 - Deposits




Deposits
are summarized as follows:




2007
            
            
            2006Savings
      accounts
            
            $
            11,696,050
            
            
            $
            12,509,816Checking
      accounts
            
            
            45,289,355
            
            
            
            29,962,467Money
      market accounts
            
            
            39,754,145
            
            
            
            53,269,562Time
      certificates of deposit accounts
            
            
            106,051,649
            
            
            
            85,226,149$
            202,791,199
            
            
            $
            180,967,994





71




Note
7 - Deposits (continued)




Scheduled
maturities of time certificates of deposit are as follows:




YEAR
      ENDINGDECEMBER
      31,
            
            AMOUNT2008
            
            $
            77,489,2552009
            
            
            20,245,6042010
            
            
            4,679,0412011
            
            
            1,468,0812012
            
            
            2,169,668$
            106,051,649





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, 2007 and 2006 was approximately $50,295,000 and $35,162,000,
respectively. Deposits in excess of $100,000 generally are not federally
insured.




Deposits
from related parties held by the Bank at December 31, 2007 and December 31,
2006, amounted to $1,154,000 and $1,043,000, respectively.




Interest
expense by deposit category is as follows:




2007
            
            
            2006Savings
      and IRA
            
            $
            130,603
            
            
            $
            158,512Checking
            
            
            320,855
            
            
            
            28,918Time
      deposits
            
            
            4,648,518
            
            
            
            3,335,352Money
      market
            
            
            1,478,458
            
            
            
            1,918,292$
            6,578,434
            
            
            $
            5,441,074





72




Note
8 - FHLB Advances




The Bank
utilizes a loan agreement with the Federal Home Loan Bank (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, 2007, the
amount available to borrow under this agreement is approximately 20% of total
assets, conditional upon meeting certain collateral and stock ownership
requirements. Borrowings outstanding at December 31, 2007 and 2006 had a
weighted-average interest rate of 4.60% and 4.84%, respectively. The Bank had
outstanding borrowings under this arrangement of $15,869,355 and $22,029,355 at
December 31, 2007 and 2006, respectively. Contractual principal repayments are
as follows:




YEAR
      ENDINGDECEMBER
      31,
            
            AMOUNT2008
            
            $
            600,0002009
            
            
            5,269,3552010
            
            
            10,000,000$
            15,869,355





YEAR
      ENDING DECEMBER 31,2007
            
            
            2006
            
            
            2005(Dollars
      in thousands)Maximum
      balance:FHLB
      advances
            
            $
            34,519
            
            
            $
            24,485
            
            
            $
            25,399Average
      balances:FHLB
      advances
            
            $
            26,511
            
            
            $
            19,824
            
            
            $
            16,239Weighted
      average interest rate:FHLB
      advances
            
            
            5.08
            %
            
            
            4.77
            %
            
            
            3.93
            %




Note
9 - 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 $97,663 and $108,176 to the
plan for the years ended December 31, 2007 and 2006, 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, 2007 and 2006
approximated $177,000 and $135,000, respectively. The Bank contributed $11,000
and $33,000 to the plan for the years ended December 31, 2007 and 2006,
respectively.






73




Note
10 - Income Taxes




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




2007
            
            
            2006Current
            
            $
            154,986
            
            
            $
            395,868Deferred
            
            
            (93,000
            )
            
            
            712,000Provision
      for income taxes
            
            $
            61,986
            
            
            $
            1,107,868





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




Provision
      at statutory rate
            
            $
            129,580
            
            
            $
            1,139,243Tax-exempt
      income
            
            
            (67,754
            )
            
            
            (38,654
            )Other
            
            
            160
            
            
            
            7,279$
            61,986
            
            
            $
            1,107,868Federal
      Tax Rate
            
            
            34.0
            %
            
            
            34.0
            %Tax
      exempt rate
            
            
            (17.8
            )
            
            
            (1.2
            )Other
            
            
            0.1
            
            
            
            0.3Effective
      tax rate
            
            
            16.3
            %
            
            
            33.1
            %





74




Note
10 - Income Taxes (continued)


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
            
            $
            100,000
            
            
            $
            46,000Nonaccrual
      interest
            
            
            4,000
            
            
            
            4,000Depreciation
            
            
            12,000
            
            
            
            (20,000
            )Other,
      net
            
            
            -
            
            
            
            76,000Total
      deferred tax assets
            
            
            116,000
            
            
            
            106,000Deferred
      tax liabilitiesAllowance
      for loan losses
            
            
            73,000
            
            
            
            166,000Federal
      Home Loan Bank stock
            
            
            142,000
            
            
            
            142,000Prepaid
      expenses
            
            
            57,000
            
            
            
            22,000Unrealized
      gain on securities
            
            
            1,000
            
            
            
            2,000Deferred
      loan fees and costs
            
            
            276,000
            
            
            
            301,000Total
      deferred tax liabilities
            
            
            549,000
            
            
            
            633,000Net
      deferred tax asset (liability)
            
            $
            (443,000
            )
            
            $
            (527,000
            )







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,
2007.
  The
Company recognizes interest accrued and penalties related to unrecognized tax
benefits in tax expense.  During the years ended December 31, 2007 and 2006
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.
  Note 11
- 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, 2007 and 2006, the Bank meets all capital adequacy requirements to
which it is subject.


75




Note
11 - Minimum Regulatory Capital Requirements (continued)




As of
December 31, 2007, 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.




To
      Be Well CapitalizedFor
      Capital
            
            
            Under
      Prompt CorrectiveActual
            
            
            Adequacy
      Purposes
            
            
            Action
      ProvisionsAmount
            
            
            Ratio
            
            
            Amount
            
            
            
            Ratio
            
            
            Amount
            
            
            
            RatioAs
      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
            %As
      of December 31, 2006Total
      Capital(to
      Risk-Weighted Assets)
            
            $
            16,391
            
            
            
            10.89
            %
            
            $
            12,042
            
            >
            
            
            8.0
            %
            
            $
            15,052
            
            >
            
            
            10.0
            %Tier
      I Capital(to
      Risk-Weighted Assets)
            
            $
            15,566
            
            
            
            10.34
            %
            
            $
            6,021
            
            >
            
            
            4.0
            %
            
            $
            9,031
            
            >
            
            
            6.0
            %Tier
      I Capital(to
      Average Assets)
            
            $
            15,566
            
            
            
            7.04
            %
            
            $
            8,843
            
            >
            
            
            4.0
            %
            
            $
            11,053
            
            >
            
            
            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):




2007
            
            
            2006Equity
            
            $
            15,888
            
            
            $
            15,569Accumulated
      other comprehensive(income)
      loss
            
            
            (3
            )
            
            
            (3
            )Total
      Tier 1 capital
            
            $
            15,885
            
            
            $
            15,566Allowance
      for loan and lease losses
            
            $
            828
            
            
            $
            822Unrealized
      gain on AFS securities
            
            
            3
            
            
            
            3Total
      capital
            
            $
            16,716
            
            
            $
            16,391





76




Note
12 - 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.




Investments - Estimated fair
values for investments 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. The impact
of delinquent loans on the estimates of the fair values described above is not
considered to have a material effect.




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
is 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.




77




Note
12 - Fair Value of Financial Instruments (continued)




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




2007
            
            
            2006Carrying
            
            
            Fair
            
            
            Carrying
            
            
            FairAmount
            
            
            Value
            
            
            Amount
            
            
            ValueFinancial
      assetsCash
      and cash equivalents
            
            $
            6,104,963
            
            
            $
            6,104,963
            
            
            $
            5,649,306
            
            
            $
            5,649,306Investments
      available-for-sale
            
            $
            71,245
            
            
            $
            71,245
            
            
            $
            169,569
            
            
            $
            169,569FHLB
      stock
            
            $
            1,319,500
            
            
            $
            1,319,500
            
            
            $
            1,319,500
            
            
            $
            1,319,500Loans,
      net
            
            $
            219,405,759
            
            
            $
            218,709,207
            
            
            $
            206,119,383
            
            
            $
            203,386,364Accrued
      interest receivable
            
            $
            1,051,476
            
            
            $
            1,051,476
            
            
            $
            895,382
            
            
            $
            895,382Financial
      liabilitiesDemand
      deposits
            
            $
            96,739,550
            
            
            $
            96,739,550
            
            
            $
            95,741,845
            
            
            $
            95,741,845Time
      deposits
            
            $
            106,051,649
            
            
            $
            106,504,696
            
            
            $
            85,226,149
            
            
            $
            86,217,772FHLB
      advances
            
            $
            15,869,355
            
            
            $
            15,884,249
            
            
            $
            22,029,355
            
            
            $
            21,930,486Accrued
      interest payable
            
            $
            210,518
            
            
            $
            210,518
            
            
            $
            121,561
            
            
            $
            121,561Advance
      payments fromborrowers
      for taxesand
      insurance
            
            $
            254,213
            
            
            $
            254,213
            
            
            $
            257,309
            
            
            $
            257,309





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.






Note
13 - 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).






Note
14 - 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






78








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 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:




2007
            
            
            2006Home
      equity
            
            $
            19,989,961
            
            
            $
            17,309,267Personal
      line of credit
            
            
            3,192,912
            
            
            
            2,915,019Business
      line of credit
            
            
            9,171,216
            
            
            
            6,061,391Construction
            
            
            2,324,413
            
            
            
            2,174,581Letters
      of Credit
            
            
            1,575,000
            
            
            
            -Residential
      mortgage
            
            
            1,406,242
            
            
            
            -$
            37,659,744
            
            
            $
            28,460,258





At
December 31, 2007, fixed rate loan commitments totaled $1,406,242 and had a
weighted average interest rate of 6.22%. At December 31, 2006, fixed rate loan
commitments totaled $4,390,933 and had a weighted average interest rate of
9.75%.




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.




79




Note
14 - Commitments and Contingent Liabilities (continued)




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, 2007 and
2006, the maximum amount of these guarantees totaled $132,829,000 and
$123,588,000, 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 2006, 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, 2007.




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, 2007 and 2006.




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.






Note
15 - Supplemental Executive Retirement Plan




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 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, 2007, the accrued liability for the SERP was $116,000 and is
included in accounts payable and other liabilities on the consolidated balance
sheet. The expense was $116,000 for the year ended December 31,
2007.




80







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




None.




Item
9A.         Controls and
Procedures.




An
evaluation of our disclosure controls and procedures (as defined in Section
13(a)-14(c) of the Securities Exchange Act of 1934 (the “Exchange Act”)) as of
December 31, 2007, was carried out under the supervision and with the
participation of the our Chief Executive Officer, Principal Financial Officer
and several other members of our senior management within the 90-day period
preceding the filing date of this annual report.  Our Chief Executive
Officer and Principal Financial Officer concluded that, as of December 31, 2007,
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.




There
were no changes in our internal controls over financial reporting (as defined in
Rule 13a-15(f) under the Act) that occurred during the quarter ended December
31, 2007, that have materially affected, or as reasonably likely to materially
affect, our internal control over financial reporting.




We do not
expect that our 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 Sound Financial have been detected.  These inherent limitations
include the realities that judgment 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.





This annual report does not include a
report of management's assessment regarding internal control over financial
reporting or an attestation report of the Company's registered public accounting
firm due to a transition period established by rules of the Securities and
Exchange Commission for newly public companies.







Item
9B.        Other
Information




None.








81








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 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.




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.  Additional information concerning the audit committee of the
Company’s Board of Directors 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.




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.




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, 2007, all Section 16(a)
filing requirements applicable to its officers, directors and greater than 10%
beneficial owners 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 is filed as Exhibit
14 to this Annual Report on Form 10-K for the year ended December 31,
2007.  A copy of the Code of Ethics is






82






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 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.




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 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.




We had no
equity compensation plans as of December 31, 2007.




Item
13.            Certain
Relationships and Related Transactions




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 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.




Item
14.            Principal
Accountant 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 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.







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:






83







Report
      of Independent Registered Public Accounting FirmConsolidated
      Balance Sheets at December 31, 2007 and 2006Consolidated
      Statements of Income for the Years Ended December 31, 2007 and
      2006Consolidated
      Statements of Equity for the Years Ended December 31,
      2007,and
      2006Consolidated
      Statements of Cash Flows for the Years Ended December 31, 2007 and
      2006Notes
      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.






















84




(a)(3)
List of Exhibits:


Exhibit
              Number
            
            Document
            
            Reference
      to
              Prior
      Filing or
              Exhibit
      Number
              Attached
              Hereto2
            
            Plan
      of Reorganization and Stock Issuance
            
            *3.1
            
            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 2008
            
            10.711
            
            Statement
      re computation of per share earnings
            
            None14
            
            Code
      of Business Conduct and Ethics
            
            1416
            
            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 Experts and Counsel
            
            None24
            
            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.







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




(c)  Financial Statements
Schedules - None


85





SIGNATURES
 
 Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
1934, the Registrant has duly caused this report to be signed on its behalf by
the undersigned, thereunto duly authorized.
 
 
 Sound
      Financial, Inc.Date:  March
      31, 2008
              By:
              /s/  Laura
      Lee
      StewartLaura
      Lee Stewart, President and Chief Executive OfficerDuly
      Authorized Representative)
 
 Pursuant
to the requirements of the Securities Exchange Act of 1934, this report has been
signed below by the following persons on behalf of the Registrant and in the
capacities and on the dates indicated.
 
 /s/  Laura Lee
      Stewart
              
              /s/Tyler K. MyersLaura
      Lee Stewart, President and Director
              
              Tyler K.
      Myers, Chairman of the Board(Principal Executive
      Officer)Date:  March
      31, 2008
              
              Date:  March
      31, 2008/s/David S. Haddad, Jr.
              
              /s/Robert F. CarneyDavid
      S. Haddad, Jr.,
      Director
              
              Robert
      F. Carney,
      DirectorDate:  March
      31, 2008
              
              Date:  March
      31, 2008/s/Debra Jones
              
              /s/Milton L. McMullenDebra
      Jones,
      Director
              
              Milton
      L. McMullen,
      DirectorDate:  March
      31, 2008
              
              Date:  March
      31, 2008/s/Rogelio Riojas
              
              /s/James E. SweeneyRogelio
      Riojas,
      Director
              
              James
      E. Sweeney,
      DirectorDate:   March
      31, 2008
              
              Date:  March
      31, 2008/s/ Matthew P. DeinesMatthew
      P. Deines, Executive Vice Presidentand
      Chief Financial Officer(Principal Financial and
      Accounting Officer)Date:  March
      31, 2008







86









INDEX
TO EXHIBITS








Number
            Description10.7
            Director
      Fee Arrangements for 200814
            Code
      of Business Conduct and Ethics31.1
            Rule
      13(a)-14(a) Certification (Chief Executive Officer)31.2
            Rule
      13(a)-14(a) Certification (Chief Financial Officer)32
            Section
      1350 Certification








87