UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549





FORM 10-Q





(Mark One)





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





For the quarterly period ended September 30, 2009





OR





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





For the transition period from _______ to ________





Commission file number:        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)
(IRS Employer Identification No.)




2005 5thAvenue, Second Floor, Seattle, Washington

98121(Address of principal executive offices)

(Zip Code)
 
 (206) 448-0884
 (Registrant’s telephone number, including area code)
 
 
 None
 (Former name, former address and former fiscal year, if changed since last report)


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





Indicate by 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 Exchange Act.





Large accelerated filer         Accelerated filer         Non-accelerated
filer        Smaller reporting company X


(Do not check if smaller


reporting company)


Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes [   ]    No [ X ]




Indicate the number of shares outstanding of each issuer's classes of common stock, as of the latest practicable date:






As of November 13, 2009, there were 2,967,895 shares of the registrant’s common stock outstanding.











SOUND FINANCIAL, INC.


FORM 10-Q


TABLE OF CONTENTS


Page NumberPART IFINANCIAL INFORMATIONItem 1.          Financial Statements (unaudited)
2Selected Notes to Consolidated Financial Statements
7Item 2.         Management's Discussion and Analysis of Financial Condition and Results of Operations
27Item 3.         Quantitative and Qualitative Disclosures About Market Risk
37Item 4T.       Controls and Procedures
37PART IIOTHER INFORMATIONItem 1.          Legal Proceedings
38Item 1A         Risk Factors
38Item 2.          Unregistered Sales of Equity Securities and Use of Proceeds
38Item 3.          Defaults Upon Senior Securities
39Item 4.          Submission of Matters to a Vote of Security Holders
39Item 5.          Other Information
39Item 6.          Exhibits
40SIGNATURESEXHIBITS








2





PART I      FINANCIAL INFORMATION





Item 1        Financial Statements


SOUND FINANCIAL, INC. AND SUBSIDIARYConsolidated Balance Sheets(Unaudited)
  SEPTEMBER 30,
2009


DECEMBER 31,
2008ASSETSCash and cash equivalents

$
13,533,391


$
5,607,800Securities available-for-sale (AFS), at fair value


35,694,062



8,929,798Federal Home Loan Bank (FHLB) stock, at cost


2,444,000



2,444,000Loans held for sale


2,665,746



955,595Loans


287,141,489



263,712,797Less allowance for loan losses


(2,526,250
)


(1,305,950
)Total loans


284,615,239



262,406,847Accrued interest receivable


1,530,816



1,219,645Premises and equipment, net


3,563,462



1,545,705Bank-owned life insurance


6,398,596



6,195,055Mortgage servicing rights


1,214,427



863,146Other real estate owned and repossessed assets


822,494



1,724,567Other assets


1,277,271



1,605,141Total assets

$
353,759,504


$
293,497,299


LIABILITIES


DepositsInterest-bearing

$
280,004,550


$
209,583,218Noninterest-bearing demand


20,451,264



13,176,999Total deposits


300,455,814



222,760,217Borrowings


25,000,000



42,219,355Accrued interest payable


228,017



259,757Other liabilities


1,935,569



1,825,143Advance payments from borrowers for taxes and insurance


570,208



330,319Total liabilities


328,189,608



267,394,791COMMITMENTS AND CONTINGENCIES (NOTE 4)STOCKHOLDERS' EQUITYPreferred stock, $0.01 par value, 1,000,000 shares authorized


-



-Common stock, $0.01 par value, 24,000,000 shares authorized, 2,967,895
shares issued and 2,899,588 outstanding as of September 30, 2009, and
2,948,063 shares issued and 2,844,059 shares outstanding as of
December 31, 2008


30,001



29,480Additional paid-in capital


11,781,041



11,936,035Unearned shares - Employee Stock Ownership Plan (“ESOP”)


(1,040,040
)


(1,057,997
)Retained earnings


15,729,793



15,987,547Accumulated other comprehensive loss, net of tax


(930,899
)


(792,557
)Total stockholders’ equity


25,569,896



26,102,508Total liabilities and stockholders’ equity

$
353,759,504


$
293,497,299


See notes to consolidated financial statements.





3








SOUND FINANCIAL, INC. AND SUBSIDIARYConsolidated Statements of Operations(Unaudited)THREE MONTHS ENDED


NINE MONTHS ENDEDSEPTEMBER 30,


SEPTEMBER 30,2009


2008


2009


2008INTEREST INCOMELoans, including fees

$
4,631,043


$
4,349,017


$
13,478,731


$
12,038,343Interest and dividends on investments,cash and cash equivalents


311,757



161,528



740,103



363,097Total interest income


4,942,800



4,510,545



14,218,834



12,401,440INTEREST EXPENSEDeposits


1,547,045



1,560,398



4,802,659



4,795,378Other interest expense


256,407



394,494



758,500



933,885Total interest expense


1,803,452



1,954,892



5,561,159



5,729,263NET INTEREST INCOME


3,139,348



2,555,653



8,657,675



6,672,177PROVISION FOR LOAN LOSSES


950,000



250,000



2,325,000



760,000NET INTEREST INCOMEAFTER PROVISION FOR LOAN LOSSES


2,189,348



2,305,653



6,332,675



5,912,177NONINTEREST INCOMEService charges and fee income


544,848



474,006



1,534,522



1,431,482Earnings on cash surrender valueof bank-owned life insurance


71,541



38,214



203,541



116,961Mortgage servicing income


179,501



76,266



639,405



251,019Gain on sale of investment


-



-



-



153,633Gain (loss) on sale of loans


(20,143
)


34,976



56,030



(10,823
)Gain on bargain purchase


226,816



-



226,816



-Loss on sale of assets


(34,294
)


(64,404
)


(588,870
)


(94,582
)Total noninterest income


968,269



559,058



2,071,444



1,847,690NONINTEREST EXPENSESalaries and benefits


1,421,141



1,323,455



4,129,336



3,626,561Operations


963,835



712,277



2,554,298



2,025,077FDIC and OTS assessment


125,857



50,357



511,095



159,261Charitable contributions


11,004



22,700



44,108



255,070Occupancy


307,070



258,820



841,832



736,523Data processing


239,922



189,023



637,362



580,170Total noninterest expense


3,068,829



2,566,632



8,718,031



7,382,662INCOME (LOSS) BEFORE PROVISION
(BENEFIT) FOR INCOME TAXES


88,788



308,079



(313,912
)


377,205PROVISION (BENEFIT) FOR INCOME TAXES


12,550



85,000



(162,289
)


74,500NET INCOME (LOSS)

$
76,238


$
223,079


$
(151,623
)

$
302,705BASIC EARNINGS (LOSS) PER SHARE

$
0.03


$
0.08


$
(0.05
)

$
0.11DILUTED EARNINGS (LOSS) PER SHARE

$
0.03


$
0.08


$
(0.05
)

$
0.11


See notes to consolidated financial statements






4








SOUND FINANCIAL, INC. AND SUBSIDIARYConsolidated Statements of Stockholders’ Equity and Comprehensive LossFor the Nine Months Ended September 30, 2009(Unaudited)Shares


Common
Stock


Additional
Paid-in
Capital


Unearned
ESOP
Shares


Retained Earnings


Accumulated Other Comprehensive Loss, net of tax


Total Stockholder EquityBalances at December 31, 2008


2,948,063


$
29,480


$
11,936,035


$
(1,057,997
)

$
15,987,547


$
(792,557
)

$
26,102,508Comprehensive loss:Net loss


-



-



-



-



(151,623
)


-



(151,623
)Net loss in fair value of investments available
for sale, net of tax benefit of $71,300


-



-



-



-



-



(138,342
)


(138,342
)Total comprehensive loss


























(289,965
)Cash dividend declared and paid (0.08 per share)


-



-



-



-



(106,131
)


-



(106,131
)Common stock issued


52,032



521



(521
)


-



-



-



-Common stock repurchased


(32,200
)


-



(226,516
)


-



-



-



(226,516
)Compensation related to stock options and restricted stock


-



-



90,000



-



-



-



90,000ESOP shares committed to be released


-



-



(17,957
)


17,957



-



-



-Balances at September 30, 2009


2,967,895


$
30,001


$
11,781,041


$
(1,040,040
)

$
15,729,793


$
(930,899
)

$
25,569,896See notes to consolidated financial statements.











5








SOUND FINANCIAL, INC. AND SUBSIDIARYConsolidated Statements of Cash Flow(unaudited)NINE MONTHS ENDEDSEPTEMBER 30,2009


2008CASH FLOWS FROM OPERATING ACTIVITIESNet income (loss)

$
(151,623
)

$
302,705Adjustments to reconcile net income (loss) to net cash from operating activities(Accretion) amortization of net discount/premium on investments


(28,062
)


(59,722
)Provision for loan losses


2,325,000



760,000Depreciation and amortization


366,178



297,709Compensation expense related to stock options and restricted stock awards


90,000



-Additions to mortgage servicing rights


(689,219
)


(246,103
)Amortization of mortgage servicing rights


337,938



245,579Increase in cash surrender value of bank-owned life insurance


(203,541
)


(116,961
)Proceeds from sale of mortgage loans


68,755,636



20,722,651Originations of mortgage loans held for sale


(74,246,826
)


(20,586,725
)Loss on sale of other real estate owned


588,870



58,971(Gain) loss on sale of loans


(56,030
)


10,823Gain on bargain purchase


(226,816
)


-Loss on sale of assets


-



35,611Changes in operating assets and liabilities:Accrued interest receivable


(311,171
)


(199,217
)Other assets


1,590,953



290,932Accrued interest payable


(31,740
)


58,716Other liabilities


110,426



211,247,Net cash used in operating activities


(1,780,027
)


1,786,216CASH FLOWS FROM INVESTING ACTIVITIESProceeds from maturities of available for sale investments


2,929,534



624,983Purchase of available for sale investments


(29,875,345
)


(9,625,201
)Cash proceeds from branch acquisitions


31,729,000



-Purchase of FHLB Stock


-



(815,000
)Net increase in loans


(22,107,977
)


(48,348,979
)Net improvements to OREO and other repossessed assets


(81,047
)


(157,304
)Proceeds from sale of OREO and other repossessed assets


2,046,904



1,408,425Purchases of premises and equipment


(1,633,935
)


(372,719
)Net cash used in investing activities


(16,992,866
)


(57,285,795
)CASH FLOWS FROM FINANCING ACTIVITIESNet increase in deposits, net of acquired deposits


44,010,597



6,605,987Proceeds from borrowings


98,530,000



36,550,000Repayment of borrowings


(115,749,355
)


(450,000
)Net proceeds from stock issuance


-



10,809,915Repurchase of common stock


(226,516
)


-Cash dividends paid


(106,131
)


(106,130
)Net change in advances from borrowers for taxes and insurance


239,889



276,876Net cash provided by financing activities


26,698,484



53,686,648INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS


7,925,591



(1,812,931
)CASH AND CASH EQUIVALENTS, beginning of period


5,607,800



6,104,963CASH AND CASH EQUIVALENTS, end of period

$
13,533,391


$
4,292,032





6








SOUND FINANCIAL, INC. AND SUBSIDIARYConsolidated Statements of Cash Flow(unaudited)SUPPLEMENTAL CASH FLOW INFORMATIONInterest paid on deposits and FHLB advances

$
5,592,899



5,670,547Non-cash transfer from loans to OREO and other repossessed assets

$
1,652,654



492,984Transfer of mortgage loans held for sale to bank portfolio

$
3,837,069



1,565,122Net assets acquired from 1st Security Bank of WashingtonAssets acquired

$
33,912,000



-Liabilities assumed

$
33,685,000



-





See
notes to consolidated financial statements.





7





SOUND FINANCIAL, INC. AND SUBSIDIARY


SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





Note 1 – Basis of Presentation





The accompanying financial information is unaudited and has been prepared from the consolidated financial statements of Sound Financial, Inc. (“we,” “us,” “our,” “Sound Financial,” or the “Company”) and its wholly owned subsidiary, Sound Community Bank (the
“Bank”).  These consolidated financial statements have been prepared in accordance with the instructions for Form 10-Q and Article 8 of Regulation S-X and do not include all disclosures required by generally accepted accounting principles (“GAAP”) for a complete presentation of the Company's financial condition and results of operations.  In the opinion of management, the information reflects all adjustments (consisting only of normal recurring adjustments) considered
necessary for a fair presentation of the consolidated financial statements in accordance with GAAP, have been included.  The results for the interim periods are not necessarily indicative of results for a full year.  For further information, refer to the consolidated financial statements and footnotes for the year ended December 31, 2008, included in the Company's Annual Report on Form 10-K.





Certain amounts in the prior quarters’ financial statements have been reclassified to conform to the current presentation.  These classifications do not have an impact on previously reported net income (loss), retained earnings or earnings (loss) per share.





Note 2 – Accounting Pronouncements Recently Issued or Adopted





In December 2007, FASB revised FASB ASC 805, Business Combinations. FASB ASC 805 establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed,
any noncontrolling interest in the acquired entity and the goodwill acquired. Furthermore, acquisition-related and other costs will now be expensed rather than treated as cost components of the acquisition. FASB ASC 805 also establishes disclosure requirements to enable the evaluation of the nature and financial effects of the business combination. The revisions to this guidance apply prospectively to business combinations for which the acquisition date occurs on or after January 1, 2009. The adoption of
revised FASB ASC 805 did not have a material impact on our consolidated financial statements as related to business combinations consummated prior to January 1, 2009.  The adoption of these revisions will increase the costs charged to operations for acquisitions consummated on or after January 1, 2009.  The branch acquisition in Note 11 was accounted for as a business combination in accordance with ASC 805.





In December 2007, FASB amended FASB ASC 810, Consolidation. This amendment establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary.  The standard also requires additional
disclosures that clearly identify and distinguish between the interest of the parent’s owners and the interest of the noncontrolling owners of the subsidiary.  This statement is effective on January 1, 2009 for the Company, to be applied prospectively. The adoption of FASB ASC 810 did not have a material impact on our consolidated financial statements.





In June 2008, FASB amended FASB ASC 260, Earnings per Share. This amendment concluded that nonvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents are participating securities and shall be included in the
computation of EPS pursuant to the two-class method. This amendment is effective for fiscal years beginning after December 15, 2008, to be applied retrospectively. The adoption of FASB ASC 260 did not have a material impact on our consolidated financial statements.





8





SOUND FINANCIAL, INC. AND SUBSIDIARY


SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





In January 2009, FASB amended FASB ASC 325-40, Investments – Other. This amendment addressed certain practice issues related to the recognition of interest income and impairment on purchased beneficial interests and beneficial interests that continue
to be held by a transferor in securitized financial assets, by making its other-than-temporary impairment (“OTTI”) assessment guidance consistent with FASB ASC 320, Investments – Debt and Equity Securities. The amendment removes the reference to the consideration of a market participant's estimates of cash flows and instead requires an assessment of whether it is probable, based on current information and events, that the holder of the
security will be unable to collect all amounts due according to the contractual terms.  If it is probable that there has been an adverse change in estimated cash flows, an OTTI is deemed to exist, and a corresponding loss shall be recognized in earnings equal to the entire difference between the investment’s carrying value and its fair value at the balance sheet date of the reporting period for which the assessment is made.  This amendment became effective for interim and annual reporting periods
ending after December 15, 2008, and is applied prospectively. The adoption of FASB ASC 325-40 did not have a material impact on our consolidated financial statements.





In April 2009, FASB amended FASB ASC 820, Fair Value Measurements and Disclosures,to address issues related to the determination of fair value when the volume and level of activity for an asset
or liability has significantly decreased, and identifying transactions that are not orderly.  The revisions affirm the objective that fair value is the price that would be received to sell an asset in an orderly transaction (that is not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions, even if the market is inactive. The amendment provides additional guidance for estimating fair value when the volume and level of activity for the
asset or liability have decreased significantly.  It also provides guidance on identifying circumstances that indicate a transaction is not orderly. If determined that a quoted price is distressed (not orderly), and thereby not representative of fair value, the entity may need to make adjustments to the quoted price or utilize an alternative valuation technique (e.g. income approach or multiple valuation techniques) to determine fair value.  Additionally, an entity must incorporate appropriate risk
premium adjustments, reflective of an orderly transaction under current market conditions, due to uncertainty in cash flows. The revised guidance requires disclosures in interim and annual periods regarding the inputs and valuation techniques used to measure fair value and a discussion of changes in valuation techniques and related inputs, if any, during the period. It also requires financial institutions to disclose the fair values of investment securities by major security type. The changes are effective for
the interim reporting period ending after June 15, 2009, and are to be applied prospectively. The adoption of FASB ASC 820 did not have a material impact on our consolidated financial statements.





In April 2009, FASB revised FASB ASC 320, Investments – Debt and Equity Securities, to change the OTTI model for debt securities. Previously, an entity was required to assess whether it has the intent and ability to hold a security to recovery in determining
whether an impairment of that security is other-than-temporary.  If the impairment was deemed other-than-temporarily impaired, the investment was written-down to fair value through earnings. Under the revised guidance, OTTI is triggered if an entity has the intent to sell the security, it is likely that it will be required to sell the security before recovery, or if the entity does not expect to recover the entire amortized cost basis of the security. If the entity intends to sell the security or it is likely
it will be required to sell the security before recovering its cost basis, the entire impairment loss would be recognized in earnings as an OTTI. If the entity does not intend to sell the security and it is not likely that the entity will be required to sell the security but the entity does not expect to recover the entire amortized cost basis of the security, only the portion of the impairment loss representing credit losses would be recognized in earnings as an OTTI.  The credit loss





9








SOUND FINANCIAL, INC. AND SUBSIDIARY


SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





is measured as the difference between the amortized cost basis and the present value of the cash flows expected to be collected of a security. Projected cash flows are discounted by the original or current effective interest rate depending on the nature of the security being measured for potential OTTI. The remaining
impairment loss related to all other factors, the difference between the present value of the cash flows expected to be collected and fair value, would be recognized as a charge to other comprehensive income (“OCI”). Impairment losses related to all other factors are to be presented as a separate category within OCI.  For investment securities held to maturity, this amount is accreted over the remaining life of the debt security prospectively based on the amount and timing of future estimated
cash flows. The accretion of the OTTI amount recorded in OCI will increase the carrying value of the investment, and would not affect earnings. If there is an indication of additional credit losses the security is reevaluated accordingly based on the procedures described above. The adoption of FASB ASC 320 did not have a material impact on our financial statements.





In April 2009, FASB revised FASB ASC 825, Financial Instruments, to require fair value disclosures in the notes of an entity's interim financial statements for all financial instruments, whether or not recognized in the statement of financial position. This
revision became effective for the interim reporting period ending after June 15, 2009.  The adoption of FASB ASC 825 did not have a material impact on our consolidated financial statements.





In May 2009, FASB amended FASB ASC 855, Subsequent Events.  The updated guidance established general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available
to be issued.  The revisions should not result in significant changes in the subsequent events that an entity reports, either through recognition or disclosure in its financial statements.  It does require disclosure of the date through which an entity has evaluated subsequent events and the basis for that date, that is, whether that date represents the date the financial statements were issued or were available to be issued.  This disclosure should alert all users of financial statements that
an entity has not evaluated subsequent events after that date in the set of financial statements being presented.  We adopted the provisions of this guidance for the interim period ended June 30, 2009, and the adoption of FASB ASC 855 did not have a material impact on our consolidated financial statements.





In June 2009, FASB issued SFAS No. 166, Accounting for Transfers of Financial Assets – an Amendment of FASB Statement No. 140.  This statement has not yet been codified into the FASB ASC.  SFAS No. 166 eliminates the concept of a qualifying special-purpose
entity, creates more stringent conditions for reporting a transfer of a portion of a financial asset as a sale, clarifies other sale-accounting criteria, and changes the initial measurement of a transferor’s interest in transferred financial assets. This statement is effective for annual reporting periods beginning after November 15, 2009, and for interim periods therein. We are currently evaluating the impact of the adoption of SFAS No. 166.





In August 2009, the FASB issued ASU 2009-05, Measuring Liabilities at Fair Value,to amend FASB ASC Topic 820 , Fair Value Measurements and Disclosures,
to clarify how entities should estimate the fair value of liabilities. FASB ASC Topic 820, as amended, includes clarifying guidance for circumstances in which a quoted price in an active market is not available, the effect of the existence of liability transfer restriction, and the effect of quoted prices for the identical liability, including when the identical liability is traded as an asset. The amended guidance in FASB ASC Topic 820 on measuring liabilities at fair value is effective for the first interim
or annual reporting period beginning after





10





August 28, 2009, with earlier application permitted. The application of the provisions of FASB ASU 2009-05 did not have a material impact on our consolidated financial statements.





In September 2009, the FASB issued ASU 2009-12, Investment in Certain Entities That Calculate Net Assets Value per Share (or Its Equivalent),to amend FASB ASC Topic 820, Fair
Value Measurements and Disclosures.T he amendments within ASU 2009-12 create a practical expedient to measure the fair value of an investment in the scope of the amendments in this ASU on the basis of the net assets value per share of the investment (or its equivalent) determined as of the reporting entity’s measurement date. It also requires disclosures by major category of investment about the attributes of those investments, such as the nature of any restriction on the investor’s ability
to redeem its investments at the measurement date, any unfunded commitments, and the investment strategies of the investees. It improves financial reporting by permitting use of a practical expedient, with appropriate disclosures, when measuring the fair value of an alternative investment that does not have a readily determinable fair value. It also improves transparency by requiring additional disclosures about investment in the scope of the amendments in this ASU to enable users of financial statements to understand
the nature and risks of investments and whether the investments are probable of being sold at amounts different from net assets value per share. The ASU is effective for interim and annual periods ending after December 15, 2009. Early application is permitted in financial statements for earlier interim and annual periods that have not been issued. We do not anticipate the adoption of this FASB ASU will have a material impact on our consolidated financial statements.





In October 2009, the FASB issued ASU 2009-13,Revenue Recognition (Topic 605): Multiple-Deliverable Revenue Arrangements – a consensus of the FASB Emerging Issues Task Force (“EITF”)
(ASC 605).T he objective of ASU 2009-13 is to address the accounting for multiple deliverable arrangements to enable vendors to account for products or services (deliverables) separately rather than as a combined unit. ASU 2009-13 provides principles and application guidance on whether multiple deliverables exits, how the arrangement should be separated,
and the consideration allocated. It requires an entity to allocate revenue in an arrangement using estimated selling prices of deliverables if a vendor does not have vendor-specific objective evidence or third-party evidence of selling price. It also eliminates the use of the residual method and requires an entity to allocate revenue using the relative selling price method. ASU 2009-13 shall be applied on a prospective basis for revenue arrangements entered into or materially modified in fiscal years beginning
on or after June 15, 2010, with earlier application permitted. We do not anticipate the adoption of this FASB ASU will have a material impact on our consolidated financial statements.





In October 2009, the FASB issued ASU 2009-15, Accounting for Own-Share Lending Arrangements in Contemplation of Convertible Debt Issuance or Other Financing.The ASU amends ASC Topic 470 and provides guidance for accounting and reporting
for own-share lending arrangements issued in contemplation of a convertible debt issuance. At the date of issuance, a share-lending arrangement entered into on an entity’s own shares should be measured at fair value in accordance with Topic 820 and recognized as an issuance cost, with an offset to additional paid-in-capital. Loaned shares
are excluded from basic and diluted earnings per share unless default of the share-lending arrangement occurs. The amendments also require several disclosures including a description and the terms of the arrangement and the reason for entering into the arrangement. The effective dates of the amendments are dependent upon the date the share-lending arrangement was entered into and include retrospective application for arrangements outstanding as of the beginning of fiscal years beginning on or after December 15,
2009. We do not anticipate the adoption of this FASB ASU will have a material impact on our consolidated financial statements.





11








SOUND FINANCIAL, INC. AND SUBSIDIARY


SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





Note 3 – Fair Value Measurements





Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.





It also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.  The standard describes three levels of inputs that may be used to measure fair value:





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





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





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





In determining the appropriate levels, the Company performs a detailed analysis of the assets and liabilities that are subject to fair value measurements.  In certain cases, the inputs used to measure fair value of an asset or liability may fall into different levels of the fair value hierarchy.  The
level within which the fair value measurement is categorized is based on the lowest level input that is significant to the fair value measurement in its entirety.  Therefore, an item may be classified in Level 3 even though there may be some significant inputs that are readily observable.





Valuation Methodologies





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





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





Loans Held for Sale - Residential mortgage loans held for sale are recorded at the lower of cost or fair value. The fair value of fixed-rate residential loans is based on whole loan forward prices obtained from government
sponsored enterprises. These loans are classified as Level 2 and are measured on a nonrecurring basis.  At September 30, 2009, loans held for sale were carried at cost.





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SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





Mortgage Servicing Rights - The fair value of mortgage servicing rights is estimated using a discounted cash flow model. These assets are classified as Level 3.  At September 30, 2009, mortgage servicing rights are carried at fair value.





Impaired Loans - The fair value of collateral dependent loans is based on the current appraised value of the collateral or internally developed models which contain management’s assumptions.  These assets are classified as level 3








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





The following table presents the balances of assets measured at fair value on a recurring basis at September 30, 2009:





Fair Value at September 30, 2009Description

Total


Level 1

Level 2


Level 3AFS Securities

$
35,694,062


$
-


$
35,694,062


$
-




Financial instruments measured at fair value on a recurring basis, which were part of the asset balances that were deemed to have Level 3 for fair value inputs when determining valuation, are identified in the table below by asset category with a summary of changes in
fair value for the three and nine month period ended September 30, 2009:





At June 30,
2009


Change
included
in
earnings


Purchases,
issuances
and
settlements


Net
Change in
Unrealized
Losses


Net
Transfers in
(out) of
Level 3


At
September 30,
2009Non-Agency Mortgage Backed Securities

$
5,269,025


$
(39,334
)

$
(282,091
)

$
(539,526
)

$
(4,408,074
)

$
-





For the three months ended September 30, 2009 there were no transfers from Level 2 to Level 3. There were $4.4 million in transfers from Level 3 to Level 2 during the three months ended September 30, 2009.  The transfers occurred as a result of the Bank’s ability to obtain quoted prices for similar assets
or liabilities in markets that are now considered active.





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SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





At
December 31,
2008


Change
included in
earnings


Purchases,
issuances
and
settlements


Net
Change in
Unrealized
Losses


Net
Transfers in
(out) of
Level 3


At
September 30,
2009Non-Agency Mortgage Backed Securities

$
3,253,011


$
34,176


$
(322,275
)

$
(499,452
)

$
(2,465,460
)

$
-





For the nine months ended September 30, 2009 there were no transfers from Level 2 to Level 3. There were $2.5 million in transfers from Level 3 to Level 2 during the three months ended September 30, 2009.  The transfers occurred as a result of the Bank’s ability to obtain quoted prices for similar assets
or liabilities in markets that are now considered active.





The following table presents the balance of assets measured at fair value on a nonrecurring basis at September 30, 2009, and the total losses resulting from these fair value adjustments for the nine months ended September 30, 2009:


Nine Months
Ended
September 30
2009Fair Value at September 30, 2009Description

Total



Level 1


Level 2


Level 3


Total LossesLoans Held for Sale

$
2,665,746




-


$
2,665,746


$
-


$
-Mortgage Servicing Rights


1,214,427




-



-



1,214,427



-OREO and Repossessed Assets


822,494




-



-



822,494



624,483Impaired Loans


13,723,006




-



-



13,723,006



1,103,386Total

$
18,425,673




-


$
2,665,746


$
15,759,927


$
1,727,869





The Company has written-down impaired loans by $1.1 million as of September 30, 2009.  At the applicable foreclosure or repossession date, OREO and other repossessed assets are recorded at the fair value of the collateral less applicable selling costs.  The carrying value of OREO and other repossessed
assets are regularly evaluated and, if necessary, an allowance is established to reduce the carrying value to net realizable value.  Loss on the sale of OREO and repossessed assets totaled $589,000 as of September 30, 2009, reflecting further decreases in collateral values compared to the foreclosure or repossession date.





There were no liabilities carried at fair value, measured on a recurring or nonrecurring basis, at September 30, 2009.
















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SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)







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.




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




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 fair value for all loans also takes into account projected credit losses as a part of the estimate.




Loans Held for Sale - Residential mortgage loans held for sale are recorded at the lower of cost or fair value. The fair value of fixed-rate residential loans is based on whole loan forward prices obtained from government
sponsored enterprises. These loans are classified as Level 2 and are measured on a nonrecurring basis.  At September 30, 2009, loans held for sale were carried at cost.




Mortgage Servicing Rights – The fair value of mortgage servicing rights is estimated using a discounted cash flow model.   These assets are classified as Level 3.  At September 30, 2009,
mortgage servicing rights are carried at fair value.




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




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




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




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
















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SOUND FINANCIAL, INC. AND SUBSIDIARY


SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)







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




September 30, 2009


December 31, 2008Carrying


Fair


Carrying


FairAmount


Value


Amount


ValueFinancial assets:Cash and cash equivalents

$
13,533,391


$
13,533,391


$
5,607,800


$
5,607,800AFS Securities


35,694,062



35,694,062



8,929,798



8,929,798Mortgage servicing rights


1,214,427



1,214,427



920,271



863,146FHLB stock


2,444,000



2,444,000



2,444,000



2,444,000Loans, net


284,615,239



286,216,997



262,406,847



263,167,112Loans held for sale


2,665,746



2,665,746



955,595



955,595Accrued interest receivable


1,530,816



1,530,816



1,219,645



1,219,645Financial liabilities:Demand deposits

$
141,714,745


$
141,714,745


$
98,079,478


$
98,079,478Time deposits


158,741,069



161,069,683



124,680,739



123,280,368Borrowings


25,000,000



24,625,630



42,419,355



41,909,153Accrued interest payable


228,017



228,017



259,757



259,757Advance payments fromborrowers for taxesand insurance


570,208



570,208



330,318



330,318





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





Note 4 – Commitments and Contingencies




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





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SOUND FINANCIAL, INC. AND SUBSIDIARY


SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)







Note  5 – Legal Proceedings




In November 2007, Visa Inc. (“Visa”) announced that it had reached a settlement with American Express and Discover Card related to antitrust lawsuits. The Company and other Visa member banks were


obligated to fund the settlement and share in losses resulting from this litigation.  The Company is not a party to the Visa litigation and its liability arises solely from the Bank’s membership interest in Visa, Inc.





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





As of September 30, 2009, the Company owned 5,699 shares of Class B common stock.  These shares are restricted and may not be transferred until the later of (i) three years from the date of the initial public offering or (ii) the period of time necessary
to resolve the covered litigation.  A conversion ratio of 0.71429 was initially established for the conversion rate of Class B shares into Class A shares.  If the funds in the escrow account are insufficient to settle all the covered litigation, Visa may sell additional Class A shares, use the proceeds to settle litigation, and further reduce the conversion ratio.  If funds remain in the escrow account after all litigation is settled, the Class B conversion ratio will be
increased to reflect that surplus.  In December 2008, Visa deposited additional funds into the escrow account to satisfy a settlement with Discover Card related to and antitrust lawsuit.  In July 2009, Visa deposited additional funds into the litigation escrow account to provide additional reserves to cover potential losses related to the two remaining litigation cases.  This deposit reduced the conversion ratio applicable to Class B shares outstanding from 0.71429 to 0.5824 per
Class A share.





As of September 30, 2009, the value of the Class A shares was $69.11 per share.  Using the new conversion ratio, the value of unredeemed Class A equivalent shares owned by the Company was $229,000, and has not been reflected in the accompanying financial statements.





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








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SOUND FINANCIAL, INC. AND SUBSIDIARY


SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





Note 6 – Loans




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




September 30,
2009


December 31, 2008


Percentage
Increase/
(Decrease )Real estate loansOne- to four-family

$
106,176,063


$
89,907,581



18.1
%Home equity


51,930,635



54,556,779



(4.8
%)Commercial


66,037,471



48,729,582



35.5
%Construction or development


10,527,788



12,220,170



(13.9
%)234,671,957



205,414,112



14.2
%Consumer loansManufactured homes


21,701,625



22,722,664



(4.5
%)Automobile


7,132,129



10,079,522



(29.2
%)Other


7,807,354



7,871,022



(0.8
%)36,641,108



40,673,208



(9.9
%)Commercial business loans


16,056,790



17,667,965



(9.1
%)287,369,855



263,755,285



9.0
%Deferred loan origination fees


(228,366
)


(42,488
)


437.5
%Allowance for loan losses


(2,526,250
)


(1,305,950
)


93.4
%Total loans, net

$
284,615,239


$
262,406,847



8.5
%





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




Nine Months Ended
September 30,2009


2008Balance at beginning of period

$
1,305,950


$
827,688Provision for loan losses


2,325,000



760,000Recoveries


97,482



130,496Charge-offs


(1,202,182
)


(561,230
)Balance at end of period

$
2,526,250


$
1,156,954








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SOUND FINANCIAL, INC. AND SUBSIDIARY


SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)




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





September 30,


December 31,2009


2008Impaired loans with a valuation allowance

$
3,397,452


$
1,250,810Valuation allowance related to impaired loans


(1,273,955
)


(581,177
)Impaired loans without a valuation allowance


10,325,554



4,914,918Total impaired loans, net of valuation allowance for impaired loans

$
12,449,051


$
5,584,551





September 30,


December 31,2009


2008Total loans past due 90-days or more and still accruing interest


-



-Average investment in impaired loans

$
9,874,537


$
4,041,000Interest income recognized on impaired loans


-



-Troubled debt restructured loans included in impaired loans

$
3,737,573


$
567,473








Forgone interest on nonaccrual loans for the nine months ended September 30, 2009 was $195,000.  At September 30, 2009, there were no commitments to lend additional funds to borrowers whose loans were classified as non-accrual or impaired.





Forgone interest on nonaccrual loans was $56,000 for the nine months ended September 30, 2008.  At December 31, 2008, there were no commitments to lend additional funds to borrowers whose loans were classified as non-accrual or impaired.





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SOUND FINANCIAL, INC. AND SUBSIDIARY


SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





Note 7 – Investments





The amortized cost and approximate fair value of our AFS Securities were as follows:




Gross Unrealized


EstimatedAmortized





Losses 1 Year


Losses Greater


FairCost


Gains


or Less


Than 1 Year


ValueSeptember 30, 2009Agency mortgage-backed
securities

$
28,186,159


$
247,713


$
(60,200
)

$
-


$
28,373,672Non-agency mortgage-backed securities


8,918,357



123,854



-



(1,721,821
)


7,320,390Total

$
37,104,516


$
371,567


$
(60,200
)

$
(1,721,821
)

$
35,694,062December 31, 2008Agency mortgage-backed
securities

$
2,007,166


$
21,596


$
-


$
-


$
2,028,762Non-agency mortgage-backed securities


8,123,476



-



(1,222,440
)


-



6,901,036Total

$
10,130,642


$
21,596


$
1,222,440
)

$
-


$
8,929,798





Agency investments with unrealized losses at September 30, 2009 had a fair value of $10.4 million and an unrealized loss of $60,000.  Non-agency investments with unrealized losses at September 30, 2009 had a fair value of $4.8 million and unrealized losses of
$1.7 million.





There were no agency investments with unrealized losses at December 31, 2008.  Non-agency investments with unrealized losses at December 31, 2008 had a fair value of $6.9 million and unrealized losses of $1.2 million.





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





20





SOUND FINANCIAL, INC. AND SUBSIDIARY


SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





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





Investments as of September 30, 2009, were mortgage-backed securities with contractual maturities between 2018 and 2039. Expected maturities of mortgage-backed securities may differ from contractual maturities because borrowers may have the right to call or prepay the obligations.





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




There were no securities sold for the periods ended September 30, 2009 and 2008.




There were $16.3 million and $2.0 million in securities pledged to the Washington State Public Funds at September 30, 2009 and December 31, 2008, respectively. There were $656,000 and $2.0 million securities pledged as collateral to the FHLB of Seattle at September 30, 2009 and December 31, 2008, respectively.




Note 8 – Borrowings





The Bank utilizes a loan agreement with the FHLB of Seattle.  The terms of the agreement call for a blanket pledge of a portion of the Bank’s mortgage and commercial real estate portfolio based on the outstanding balance.  At September 30, 2009,
the amount available to borrow under this agreement is approximately 35% of total assets, conditional upon meeting certain collateral and stock ownership requirements.  The Bank had unused borrowing capacity of $86.6 million and $31.0 million and outstanding borrowings of $25.0 million and $42.2 million at September 30, 2009, and December 31, 2008, respectively.




The Bank participates in the Federal Reserve Bank’s Borrower-in-Custody program, which gives the Bank access to the discount window.  The terms of the program call for a pledge of specific assets.  The Bank had unused borrowing capacity of $24.8
million and $0 and outstanding borrowings of $0 and $0 under this program at September 30, 2009 and December 31, 2008, respectively.




The Bank has access to a line of credit from the Pacific Coast Banker’s Bank.  This line of credit is equal to $2.0 million as of September 30, 2009.  The line has a one-year term and is renewable.  There was no balance on this line of
credit as of September 30, 2009 and December 31, 2008.







21





SOUND FINANCIAL, INC. AND SUBSIDIARY


SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)







Note 9 – Earnings Per Share




Earnings per share are summarized in the following tables:


Three Months EndedSeptember 30, 2009

September 30, 2008Net income

$
76,238


$
223,079Weighted-average common shares
outstanding


2,903,314



2,836,951Basic earnings per share

$
0.03


$
0.08Diluted earnings per share

$
0.03


$
0.08


Nine Months EndedSeptember 30, 2009

September 30, 2008Net income (loss)

$
(151,623
)

$
302,705Weighted-average common shares
outstanding


2,899,588



2,836,951Basic earnings (loss) per share

$
(0.05
)

$
0.11Diluted earnings (loss) per share

$
(0.05
)

$
0.11





For the nine months ended September 30, 2009, all outstanding stock equivalents were determined to be antidilutive and accordingly were not included in the diluted earnings per share calculation.  There were no outstanding stock equivalents for the nine months
ended September 30, 2008.





Note 10 – Stock-Based Compensation





In November 2008, the Company’s shareholders approved the Sound Financial, Inc. 2008 Equity Incentive Plan (“Plan”).  The Plan provides for the grant of stock options, awards of restricted stock and stock appreciation rights.  Total compensation cost that has been charged against
income for awards granted pursuant to the Plan and the related income tax benefit was $90,000 and $20,000, respectively, for the nine months ended September 30, 2009.





Stock Options





The Plan authorized the grant of stock options for up to 144,455 shares to its directors, officers and employees.  Option awards to purchase Company common stock are granted at an exercise price of not less than the market price of the Company’s common stock at the date of grant.  Option awards
have a vesting period of no less than five years, with 20% vesting on the anniversary date of each grant date, and a contractual life of ten years.  Any unexercised stock options expire ten years after the grant date or one year after employment or service ends.  The Company has a policy of issuing new shares upon exercise.








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SOUND FINANCIAL, INC. AND SUBSIDIARY


SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





Options for 108,398 shares of common stock were awarded in January 2009 at exercise prices equal to and greater than the market price of the Company’s common stock on the grant date.  Options for 36,057 shares of common stock remain available for grant under the Plan.





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





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





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





Annual dividend yield


2.20
%Expected volatility


30.00
%Risk-free interest rate


2.09
%Expected term

7.5 yearsWeighted-average grant date fair value per option granted

$
2.56








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SOUND FINANCIAL, INC. AND SUBSIDIARY


SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





The following is a summary of the Company’s stock option plan awards during the nine months ended September 30, 2009:





Shares


Weighted-
Average
Exercise Price


Weighted-
Average
Remaining
Contractual
Term In
Years


Aggregate
Intrinsic
ValueOutstanding at the beginning of the year


-


$
-Granted


108,398



7.93Exercised


-



-Forfeited or expired


-



-Outstanding at September 30, 2009


108,398


$
7.93



9.34


$
-Expected to vest, assuming a 0% forfeiture
rate over the vesting term


108,398


$
7.93



9.34


$
-





The aggregate intrinsic value of the stock options as of September 30, 2009 was $0.





As of September 30, 2009, there was $239,000 of total unrecognized compensation cost related to nonvested stock options granted under the Plan.  The cost is expected to be recognized over the remaining weighted-average vesting period of 4.34 years.  No options were exercisable at September 30, 2009.





Restricted Stock Awards





The Plan authorized the grant of restricted stock awards amounting to 57,782 shares to directors, officers and employees.  Compensation expense is recognized over the vesting period of the awards based on the fair value of the stock at the date of grant.  The restricted stock awards’ fair value
is equal to the value on the date of grant.





Shares awarded as restricted stock vest ratably over a five-year period beginning at the grant date with 20% vesting on the anniversary date of each grant date.  In January 2009, 52,032 shares of restricted stock were issued.





There are 5,750 shares available under the Plan for additional restricted stock awards.  In November 2008, the Board of Directors authorized management to repurchase up to 57,782 shares of the Company’s outstanding stock over a twelve-month period in order to fund the restricted stock awards made under
the Plan.  As of September 30, 2009, 32,200 shares have been repurchased under the plan.





24





SOUND FINANCIAL, INC. AND SUBSIDIARY


SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





The following is a summary of the Company’s nonvested restricted stock awards for the nine months ended September 30, 2009:


Nonvested Shares

Shares


Weighted-Average Grant-Date Fair Value


Aggregate Intrinsic ValueNonvested at January 1, 2009


-



-Granted


52,032


$
7.35Vested


-



-Forfeited


-



-Nonvested at September 30, 2009


52,032


$
7.35


$
5.45-Expected to vest assuming a 0% forfeiture rate over the vesting term


52,032


$
7.35


$
5.45





The aggregate intrinsic value of the restricted stock options as of September 30, 2009 was $284,000.





As of September 30, 2009, there was $331,000 of unrecognized compensation cost related to non-vested restricted stock granted under Plan.  The cost is expected to be recognized over the weighted-average vesting period of 4.34 years.





Note 11 – Acquisition of 1st Security Bank of Washington Branches





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





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





The acquisition was accounted for under the purchase method of accounting in accordance with FASB ASC Topic 805, Business Combinations.  The assets acquired and liabilities assumed were recorded at fair value.  Fair values are preliminary and are subject to refinements for up to one year after the
closing date of an acquisition as information relative to closing date fair values becomes available.  As











25





SOUND FINANCIAL, INC. AND SUBSIDIARY


SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





of September 30, 2009, the fair values for acquired assets and liabilities remained open.  A “bargain purchase gain” totaling approximately $227,000 resulted from the acquisition and is included as a component of noninterest income on the consolidated statement of operations.  The amount
of gain is equal to the amount by which the fair value of assets purchased exceeded the fair value of liabilities assumed.  The estimated fair value of the assets purchased and liabilities assumed are presented in the following table:




Fair value of assets acquired

August 29, 2009Cash and cash equivalents

$
31,729,000Loans, net


241,000Premises and equipment, net


750,000Core deposit intangibles


1,160,000Other assets


32,000Total fair value of assets acquired

$
33,912,000Fair value of liabilities assumedDeposits

$
33,553,000CD negative premium


132,000Total fair value of liabilities assumed

$
33,685,000Gain on bargain purchase

$
227,000





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





The following table represents unaudited pro forma results of operations for the nine months ended September 30, 2009 and 2008, as if the acquisition of the 1st Security branches had occurred at the beginning of the earliest period presented.  The pro forma results have been prepared for comparative purposes
only by estimating net interest income, non-interest income and non-interest expense for the nine month periods as if the acquisition had occurred at the earliest period presented and are not necessarily indicative of the results that would have been obtained had the acquisitions actually occurred at the beginning of the earliest period presented.  Management of the Bank anticipates that cost savings and operational synergies not currently reflected will be realized when the operations of 1st Security
Bank of Washington are fully integrated in 2009.  Acquisition related expenses of approximately $132,000 were expensed in the current period.








26





SOUND FINANCIAL, INC. AND SUBSIDIARY


SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)





Nine Months Ended September 30,2009


2008Net interest income

$
9,524,000


$
7,476,000Provision for loan losses


2,325,000



760,000Non-interest income


2,251,000



2,028,000Non-interest expense


9,439,000



8,103,000Income before income taxes


11,000



641,000Provision (benefit) for income taxes


(52,000
)


164,000Net Income

$
63,000


$
477,000







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




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




The revenue and earnings since the acquisition date (August 29, 2009) included in the consolidated financial statements as of and for the three and nine months ended September 30, 2009, are not considered significant.




Note 12 – Subsequent Events





Subsequent events are events or transactions that occur after the balance sheet date but before financial statements are issued.  Recognized subsequent events are events or transactions that provide additional evidence about conditions that existed at the date
of the balance sheet, including the estimates inherent in the process of preparing financial statements.  Nonrecognized subsequent events are events that provide evidence about conditions that did not exist at the date of the balance sheet but arose after that date.  Management has reviewed events occurring of the balance sheet but arose after that date.  Management has reviewed events occurring through November 13, 2009, the date the financial statements were available for
issuance and no subsequent events occurred requiring accrual or disclosure.





27





Item 2  Management’s Discussion and Analysis of Financial Condition and Results of Operations


Forward-Looking Statements





This report contains statements that are not historical or current fact and constitute forward-looking statements.  In some cases, you can identify these statements by words such as "may", "might", "will", "should", "expect", "plan", "intend", "anticipate", "believe", "estimate", "predict", "potential", or
"continue", the negative of these terms and other comparable terminology.  Such forward-looking statements, which are based on various underlying assumptions and expectations and are subject to risks, uncertainties and other unknown factors, may include projections of our future financial performance based on our growth strategies and anticipated trends in our business.  These statements are only predictions based on our current expectations and projections about future events, and there are
or may be important factors that could cause our actual results to be materially different from the historical results or from any future results expressed or implied by such forward-looking statements.  Unless required by law, we undertake no obligation to publicly update or revise any forward-looking statement to reflect circumstances or events after the date of this report.





Our results of operations and business are subject to various factors which could cause actual results to differ materially from these estimates and most other statements that are not historical in nature.  These factors include, but are not limited to, the credit risks of lending activities, including changes
in the level and trend of loan delinquencies and write-offs, which may be affected by the deterioration in the housing and commercial real estate markets; changes in general economic conditions, either nationally or in our market areas; changes in the levels of general interest rates and the relative differences between short and long-term interest rates, deposit interest rates, our net interest margin and funding sources, fluctuations in the demand for loans and in real estate values in our market areas; our
ability to control operating costs and expenses, including further FDIC insurance premiums; the use of estimates in determining fair value of certain of our assets, which estimates may prove to be incorrect or result in significant declines in valuation; our ability to successfully implement our branch acquisitions; our ability to successfully integrate any assets, liabilities, customers, systems, and management personnel we may acquire into our operations and our ability to realize related revenue synergies
and cost savings within expected time frames; our ability to manage loan delinquency rates; our ability to retain key members of our senior management team; costs and effects of litigation including settlements and judgments; increased competitive pressures among financial services companies; changes in consumer spending, borrowing and savings habits; legislative or regulatory changes that adversely affect our business; adverse changes in the securities markets; changes as a result of financial institution regulatory
agencies or the Financial Accounting Standards Board; other economic competitive, governmental, regulatory, and technological factors affecting our operations, pricing, products and services and other risks detailed from time to time in our filings with the Securities and Exchange Commission.  We caution readers not to place undue reliance on any forward-looking statements. These risks could cause our actual results to differ materially from those expressed in any forward-looking statements by, or on
behalf of us.




General




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




In connection with its organization, Sound Financial sold 1,297,148 shares of common stock to investors at $10.00 per share in a subscription offering, which closed on January 8, 2008.  Those shares constitute 44% of the outstanding shares of common stock of Sound Financial.  In connection with the
closing of the offering, Sound Financial also issued 29,480 shares of common stock to Sound Community Foundation, a charitable foundation created by the Bank in connection with the mutual holding company





28





reorganization and subscription offering.  The remaining 1,621,435 shares of common stock of Sound Financial outstanding were issued in accordance with federal law to Sound Community MHC, a federal mutual holding company (“MHC”).





Sound Financial raised $12,971,480 in its public offering and after paying $1,005,000 in offering expenses, it contributed $8,000,000 to the Bank, lent $1,155,600 to fund its employee stock ownership plan’s purchase of shares in the offering, and retained the remaining $2,810,880 for working capital.  In
March 2009, Sound Financial contributed an additional $1 million to the Bank in order to support anticipated growth in 2009 and to increase capital levels at the Bank.  During the quarter ended September 30, 2009, the Company paid a dividend of $0.04 per share to all shareholders of record on May 25, 2009.





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





As part of our business, we focus on residential 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 $97.8 million and $45.4 million
in one- to four-family residential mortgage loans during the nine months ended September 30, 2009 and 2008, respectively.  During these same periods, we sold $68.7 million and $20.7 million, respectively, of one- to four-family residential mortgage loans.  All one- to four-family residential mortgage loans that conform to Fannie Mae’s underwriting standards are sold with servicing retained.  Non-conforming one- to four-family residential as well as all commercial and consumer
loans are held in the Bank’s portfolio.




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 on FHLB advances to augment our deposits and fund the growth of interest earning assets.  We have implemented a strategy to use long-term FHLB advances
to fund asset and loan growth and short-term FHLB advances to meet short-term liquidity needs. In addition, we have access to a line of credit through the Federal Reserve Bank’s discount window.  The Bank may also use funds from the discount window to meet short-term liquidity needs.  The 1st Security deposit acquisition as well as organic deposit growth has allowed the Bank to pay off all of its overnight borrowings as of September 30, 2009.




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




See “Difficult market conditions and economic trends have adversely affected our industry and our business.” and “Recent legislative and regulatory initiatives to address these difficult market and







29





economic conditions may not stabilize the U.S. banking system.” in Item 7 of our Form 10-K Annual Report for the year ended December 31, 2008 for information about economic conditions and recent Federal laws and regulations that impact our operations in 2009.  Since the filing of that Form 10-K, the
increase in deposit insurance from $100,000 to $250,000 was extended until December 31, 2013.




In April 2009, we entered into a Purchase and Assumption Agreement with 1st Security Bank of Washington (“1stSecurity”) for the acquisition of their Port Angeles Office.  In that transaction, we purchased the office building
and deposit-related loans, and assumed all of the deposits at the branch facility.  In June 2009, we entered into another Purchase and Assumption Agreement with 1st Security, pursuant to which we purchased the deposit-related loans and assumed the deposits and lease agreement of 1st Security’s branch facility in Tacoma, Washington.  The acquisition of the new Tacoma and Port Angeles Offices closed on August 29, 2009.  The deposits we acquired at the Port Angeles and Tacoma
Offices totaled approximately $33 million.




We consolidated the operations of the acquired Port Angeles Office to our new branch location at 110 North Alder Street in Port Angeles during the third quarter of 2009.  We consolidated the operations of our Lakewood Towne Center branch to the Tacoma branch office during the fourth quarter of 2009.




Critical Accounting Policies




We consider accounting policies involving significant judgments and assumptions by management that have, or could have, a material impact on the carrying value of certain assets or on income to be critical accounting policies. We consider our critical accounting policies to be those related to our allowance for loan
losses, mortgage serving rights, other real estate owned, and deferred tax asset accounts.  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 U.S. generally accepted accounting principles.  It is management’s best estimate of probable incurred credit losses in our loan portfolio.  Our methodologies for analyzing the allowance for loan losses, mortgage serving rights, other real
estate owned, and deferred taxes are described in our Form 10-K Annual Report for the year ended December 31, 2008.




Comparison of Financial Condition at September 30, 2009 and December 31, 2008




General.  Total assets increased by $60.3 million, or 20.5%, to $353.8 million at September 30, 2009 from $293.5
million at December 31, 2008.  The increase was driven primarily by two factors.  First, was a $26.8 million, or 299.7%, increase in available for sale securities.  Second, was a $25.1 million increase in our gross loan portfolio, including loans held for sale, from $264.7 million at December 31, 2008 to $289.8 million at September 30, 2009.  Additionally, premises and equipment increased $2.0 million or 131.0% primarily as a result of leasehold improvements related to
our new branch facility in Port Angeles and the acquisition of the existing 1st Security branch facility in Tacoma.  The increase in total assets was funded primarilyby a $77.7 million increase in deposits during the nine months ended September 30, 2009.




Loans.  Our loan portfolio, including loans held for sale, increased $25.1 million, or 9.5%, to $289.8 million at September 30, 2009, from $264.7 million at December 31, 2008.  Loans held for sale increased from $956,000 at
December 31, 2008 to $2.7 million at September 30, 2009, reflecting the timing of transactions and increased mortgage originations during the quarter.The changes in our net loan portfolio are reflected in Note 6 to our financial statements above.  The most significant changes include a 35.5% increase in our commercial real estate portfolio, an 18.1% increase in our one-to-four family real estate loans and a 29.2% decrease in automobile loans.  The
increases in one-to-four and commercial real estate are consistent with our operating strategy of growing and diversifying our loan







30





portfolio.  The decrease in the consumer loan portfolio is a result of the general state of the economy, and is heavily impacting auto and other consumer purchases.




Allowance for Loan Losses.  Our allowance for loan losses at September 30, 2009, was $2.5 million, or 0.89% of net loans receivable, compared to $1.3 million, or 0.50%,
of net loans receivable at December 31, 2008.  This 93.4% increase reflects the $2.3 million provision for loan losses recorded during the nine months ended September 30, 2009, as a result of increases in our commercial and first mortgage loan portfolios in the 2009 period and an evaluation of prevailing housing and other market conditions and net charge-offs of non-performing loans totaling $1.1 million.  Non-performing loans increased to $3.8 million at September 30, 2009, from $1.4 million
at December 31, 2008.  The increase was concentrated in one commercial development loan as well as numerous one- to four-family residential first and second mortgage loans.  Non-performing loans to total loans increased to 1.34% at September 30, 2009, from 0.53% at December 31, 2008, due to declining economic conditions and increased delinquencies.  Other real estate owned and repossessed assets decreased by $902,000, or 52.3%, during the nine months ended September 30, 2009. We
sold four properties totaling $1.8 million at a loss of $258,000 in the nine month period and acquired seven new properties valued at $1.2 million in foreclosure and other actions.  The Company believes that higher non-performing assets and charge-offs will continue going forward until the housing market and general market conditions begin to recover.




Cash, Cash Equivalents and Securities.  Cash and cash equivalents increased by $7.9 million, or 141.3%, to $13.5 million at September 30, 2009.  This was primarily a result of the closing of the 1st Security branch transactions.  Our
securities portfolio consists of agency and non-agency mortgage-backed securities, all of which are designated as available-for-sale and FHLB stock, which is carried at cost.  The securities portfolio increased by $26.8 million, or 299.7%, to $38.1 million at September 30, 2009 from $11.4 million at December 31, 2008.  This increase reflects the purchase of agency mortgage-backed securities, which were purchased with the cash obtained in connection with the 1st Security branch transactions
and which will also be used as collateral to meet the new higher collateralization requirements and the shared risk exposure under Washington state regulations.  These regulations have not altered the bank’s strategy regarding holding public funds as we have sufficient securities to pledge and ample liquidity.




Our investment portfolio also includes $7.3 million in non-agency mortgage-backed securities.  These securities present a level of credit risk that does not exist currently with agency backed securities that are guaranteed by the United States government.  In order to monitor the risk of these securities,
management receives a credit surveillance report that considers various factors for each security including original credit scores, loan to value, geography, delinquency and loss history.  The report also evaluates the underlying loans within the security to project future losses based on various home price depreciation scenarios over a three year horizon.  Based on this analysis as of September 30, 2009, management does not expect to incur any principal loss on any of these investments.




At September 30, 2009, we held $2.4 million in shares of FHLB stock. FHLB stock is carried at par and does not have a readily determinable fair value. Ownership of FHLB stock is restricted to the FHLB and member institutions, and can only be purchased and redeemed at par. Due to ongoing turmoil in the capital and mortgage
markets, the FHLB of Seattle has a risk-based capital deficiency largely as a result of write-downs on its private label mortgage-backed securities portfolios. Management evaluates FHLB stock for impairment. Management’s determination of whether these investments are impaired is based on their assessment of the ultimate recoverability of cost rather than by recognizing temporary declines in value. The determination of whether a decline affects the ultimate recoverability of cost is influenced by criteria
such as: (1) the significance of any decline in net assets of the FHLB as compared to the capital stock amount for the FHLB and the length of time this situation has persisted, (2) commitments by the FHLB to make payments required by law or regulation and the level of such





31





payments in relation to the operating performance of the FHLB, (3) the impact of legislative and regulatory changes on institutions and, accordingly, the customer base of the FHLB and (4) the liquidity position of the FHLB. Under Federal Housing Finance Agency Regulations, a Federal Home Loan Bank that fails to meet
any regulatory capital requirement may not declare a dividend or redeem or repurchase capital stock in excess of what is required for members’ current loans. Based upon an analysis by Standard and Poor’s regarding the Federal Home Loan Banks they stated that the FHLB System has a special public status (organized under the Federal Home Loan Bank Act of 1932) and because of the extraordinary support offered to it by the U.S. Treasury in a crisis, (though not used), it can be considered an extension
of the government. The U.S. government would almost certainly support the credit obligations of the FHLB system. Based on the above, we have determined there is not an other-than-temporary impairment on the FHLB stock investment as of September 30, 2009.





Deposits.  Total deposits increased by $77.7 million, or 34.9%, to $300.5 million at September 30, 2009, from $222.8 million at December 31, 2008.  Time deposits increased $34.1 million, money market accounts increased $25.4
million, demand deposits and interest-bearing checking accounts increased $4.4 million and savings accounts increased $6.6 million.  This increase in deposits reflects a Bank-wide emphasis to bring additional core deposits to the Bank from our existing consumer and business customers, an emphasis on increasing public deposits and the 1st Security branch acquisitions.




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




As of September 30, 2009


As of December 31, 2008Amount


Wtd. Avg.
Rate


Amount


Wtd. Avg
RateChecking (noninterest)

$
20,451,264



0.00
%

$
13,176,999



0.00
%NOW (interest)


24,982,330



0.28
%


20,636,576



0.61
%Savings


19,180,088



0.30
%


12,521,879



0.75
%Money Market


77,101,063



0.96
%


51,744,024



2.92
%CDs


158,741,069



3.31
%


124,680,739



4.11
%Total

$
300,455,814



2.04
%

$
222,760,217



3.04
%







Borrowings.  Total borrowings decreased $17.2 million, or 40.8% to $25.0 million at September 30, 2009 from $42.2 million at December 31, 2008.  During the quarter, the Bank paid off the entirety of its overnight borrowings
at the FHLB and the Federal Reserve Bank’s discount window using the excess liquidity provided by the assumption of deposits in the 1st Security transactions.  The weighted average cost of borrowings at September 30, 2009 was 3.66%, while our weighted average cost of deposits was 2.04%.




Equity.  Total equity decreased $533,000, or 2.4%, to $25.6 million at September 30, 2009, from $26.1 million at December 31, 2008.  This primarily reflects $227,000
in stock repurchases, $106,000 in dividends paid, net losses of $152,000 and a $138,000 increase in accumulated other comprehensive loss.







32





Comparison of Results of Operation for the Three and Nine Months Ended September 30, 2009 and 2008




General.  Net income decreased $147,000 to $76,000 for the three months ended September 30, 2009 compared to net income of $223,000 for the three months ended September 30, 2008.  The primary reasons for this decrease were
a $700,000 increase in the provision for loan losses, a $512,000 increase in non-interest expense primarily as a result of higher FDIC and OTS assessments and expanded branch operations in Port Angeles and Tacoma.  These expense increases were offset by a $409,000 increase in non-interest income including a $227,000 gain recognized as a result of the 1st Security transaction.




Net income decreased $455,000 to a loss of $152,000 for the nine months ended September 30, 2009 compared to net income of $303,000 for the nine months ended September 30, 2008.  The primary reasons for this decrease were a $1.6 million increase in the
provision for loan losses, a $352,000 increase in FDIC and OTS assessments and increases in operation expenses related to expanded branch operations in Port Angeles and Tacoma.  These expense increases were offset by a $2.0 million increase in net interest income, and a $388,000 increase in mortgage servicing income.




Interest Income.  Interest income increased by $433,000, or 9.6%, to $4.9 million for the three months ended September 30, 2009 from $4.5 million for the three months ended September 30, 2008.  The increase in interest income
for the period reflects an increased amount of loans and securities outstanding during the 2009 period, despite lower rates overall.  The weighted average yield on loans decreased from 6.60% for the three months ended September 30, 2008, to 6.45% for the three months ended September 30, 2009.  The decrease was primarily the result of the decrease in the 1 year Treasury bill rate which we use to set and adjust loan rates for certain variable rate loans.  The weighted average yield
on investments was 4.42% for the three months ended September 30, 2009, compared to 6.84% for the comparable period in 2008.




Interest income increased by $1.8 million, or 14.7%, to $14.2 million for the nine months ended September 30, 2009 from $12.4 million for the nine months ended September 30, 2008.  The increase in interest income for the period reflects the increased amount of loans and securities outstanding during the 2009
period.  These increases were partially offset by a decrease in the overall number of consumer loans.




The weighted average yield on loans decreased from 6.26% for the nine months ended September 30, 2008, to 6.09% for the nine months ended September 30, 2009.  The decrease was primarily the result of the decrease in the 1 year Treasury bill rate which we use to establish and adjust loan rates for certain variable
rate loans.  The decrease in the weighted average yield on loans, however, was tempered by the increase in commercial loans, which typically have higher yields, as a percentage of the entire loan portfolio and an increase in the origination of single-family mortgage loans.  The weighted average yield on investments was 5.44% for the nine months ended September 30, 2009 compared to 7.13% for the same period during 2008, reflecting generally lower market interest rates.




Interest Expense.  Interest expense decreased $151,000, or 7.7%, to $1.8 million for the three months ended September 30, 2009, from $2.0 million for the three months ended September 30, 2008.  Interest expense decreased $168,000,
or 2.9%, to $5.6 million for the nine months ended September 30, 2009, from $5.7 million for the nine months ended September 30, 2008.




The decrease in interest expense for the 2009 three month period reflects the overall lower interest rates paid on deposits which were partially offset by a substantial increase in deposits.  Our weighted average cost of interest-bearing liabilities was 2.06% for the three months ended September 30, 2009, compared
to 2.80% for the same period in 2008. Our weighted average cost of interest-bearing







33





liabilities was 2.13% for the nine months ended September 30, 2009, compared to 2.87% for the same period in 2008.




Interest paid on deposits decreased $13,000, or 0.9%, to $1.5 million for the three months ended September 30, 2009, from $1.6 million for the three months ended September 30, 2008.  The decrease for the three month period resulted primarily from a decrease in the weighted average cost of deposits which was
partially offset by a $55.9 million increase in the average balance of deposits outstanding for the period.  We experienced a 74 basis point decrease in the average rate paid on deposits during the three-months ended September 30, 2009 compared to the same period in 2008.  This decrease in average rates was a result of the repricing of matured certificate deposits that the Bank was able to retain at significantly lower rates as well as lower interest rates paid on savings, interest bearing
checking and money market accounts.




Interest paid on deposits increased $7,000, or 0.2%, to $4.8 million for the nine months ended September 30, 2009, from $4.8 million for the nine months ended September 30, 2008.  The increase for the nine month period resulted primarily from a $66.2 million increase in the average balance of deposits outstanding
for the period, partially offset by a decrease in the weighted average cost of deposits.  We experienced a 74 basis point decrease in the average rate paid on deposits during the nine months ended September 30, 2009 compared to the same period in 2008.  This decrease in average rates was a result of the repricing of matured certificate deposits that the Bank was able to retain at significantly lower rates as well as lower interest rates paid on savings and money market accounts.




Interest expense on borrowings decreased $138,000, or 35.0%, to $256,000 for the three months ended September 30, 2009 from $394,000 for the three months ended September 30, 2008.  The decrease resulted from a $1.2 million or 3.6% reduction in our average balance of outstanding overnight borrowings at the FHLB.  The
cost of borrowings increased 36 basis points from 3.74% in the 2008 period to 4.10% in the 2009 period due to the reduction in overnight borrowings that carry a lower interest rate than the $25.0 million in term debt outstanding.




For the nine months ended September 30, 2009, interest expense on borrowings decreased $175,000, or 18.8%, to $759,000 from $934,000 for the nine months ended September 30, 2008.  The decrease resulted from an $11.2 million, or 24.3% decrease in our average balance of  overnight balances at the FHLB
during the current period compared to the 2008 period.  The cost of borrowings from the FHLB increased 111 basis points from 2.95% in the 2008 period to 4.06% in the 2009 period due to the reduction in overnight borrowings that carry a lower interest rate than the $25.0 million in term debt outstanding.




Net Interest Income.  Net interest income increased $584,000, or 22.8%, to $3.1 million for the three months ended September 30, 2009, from $2.6 million for the three months ended September 30, 2008.  The increase in net interest
income for the three-month period primarily resulted from the increased amount of loans and securities outstanding during the 2009 period.  Our net interest margin was 3.89% for the three months ended September 30, 2009, compared to 3.79% for the three months ended September 30, 2008.




Net interest income increased $2.0 million, or 29.8%, to $8.7 million for the nine months ended September 30, 2009, from $6.7 million for the nine months ended September 30, 2008.  The increase in net interest income for the nine-month period primarily
resulted from the higher average balance of  loans and securities outstanding during the 2009 period.  Our net interest margin was 3.57% for the nine months ended September 30, 2009, compared to 3.59% for the same period ended September 30, 2008.







34





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




A provision for loan losses of $950,000 was recorded for the three months ended September 30, 2009, compared to $250,000 for the three months ended September 30, 2008.  A provision for loan losses of $2.3 million was recorded for the nine months
ended September 30, 2009, compared to $760,000 for the nine months ended September 30, 2008.  The increased provision was primarily attributable toincreases in net charge-offs and impaired loans, deteriorating market conditions, increases in our commercial loan portfolio andan increase in our overall loan portfolio.  The Company believes that higher levels of non-performing assets and charge-offs will continue until the housing
market and general economic market conditions begin to recover.




For the nine months ended September 30, 2009, the annualized ratio of net charge-offs to average loans increased 30 basis points to 0.54% from 0.24% compared to the nine months ended September 30, 2008.  The ratio of non-performing loans to total loans increased from 0.53% at December 31, 2008 to 1.34% at September
30, 2009.




Noninterest Income.  Noninterest income increased $409,000, or 73.2%, to $968,000 for the three months ended September 30, 2009, from $559,000 for the three months ended September 30, 2008.  The
primary reason for this increase during the 2009 period was a $227,000 gain recognized as a result of the 1st Security transaction.  Additional reasons include a $103,000 increase in mortgage servicing income, a $71,000 increase in service charges and fee income, a $33,000 increase in BOLI income and offset by a $55,000 increase in loss on loan sales for the quarter ended September 30, 2009 compared to the same period in 2008. The increase in mortgage servicing income was the result of a recent
increase in refinance mortgage activity due to the historically low interest rate environment.




Noninterest income increased $224,000, or 12.1%, to $2.1 million for the nine months ended September 30, 2009, from $1.8 million for the nine months ended September 30, 2008. The primary reasons for this increase were a $388,000 increase in mortgage servicing income as a result of a recent increase in refinance mortgages
due to the historically low interest rate environment, a $227,000 gain recognized as a result of the 1st Security transaction, a $103,000 increase in service charges and fee income, an $87,000 increase in BOLI income, and a $67,000 increase in gain on loan sales.  These increases were offset by a $154,000 decrease in gain on sale of investments.




The decrease of $154,000 in gains on investment sales was a result of sale of investments resulting from the mandatory redemption of a portion of our Class B Visa, Inc. shares as part of Visa’s initial public offering.  The Bank obtained its Visa
shares because it was a long-time Visa member, prior to the sale of its credit card portfolio in 2006.  We continue to own 5,699 shares of Visa Class B shares that are convertible into Class A shares.  Each Class B share currently is convertible into 0.5824 Class A shares, which are traded on the New York Stock Exchange.  The amount of Class A shares the Bank could realize upon conversion of its Class B shares are expected to change as Visa issues additional Class A shares to fund
the escrow account to cover the remaining Discover settlements.  The Class B shares carry a three-year lock-up provision and may not be converted or redeemed during that period.  If those







35





shares could be converted as of September 30, 2009, they would have a market value of approximately$229,000.




Noninterest Expense.  Noninterest expense increased $512,000, or 20.0%, to $3.1 million for the three months ended September 30, 2009, compared to $2.6 million for the three months ended September 30, 2008.  The increase in
the 2009 period was primarily the result of a $252,000 increase in operations expense, a $98,000 increase in salary and benefits, a $76,000 increase in FDIC and OTS assessment expenses, a $51,000 increase in data processing expense, and a $48,000 increase in occupancy expense.  The increases in operations, occupancy, salary and benefits are primarily a result of expanded branch operations in Port Angeles and Tacoma in the 2009 period as well as expenses related to the 2008 Equity Incentive Plan.  The
increase in FDIC and OTS assessments is due to an industry-wide increase in assessment rates.  The increase in data processing was a result of conversion expenses relating to the 1st Security deposit conversion.




Noninterest expense increased $1.3 million, or 18.1%, to $8.7 million for the nine months ended September 30, 2009, compared to $7.4 million for the nine months ended September 30, 2008.  The increase in the 2009 period was primarily the result of a $503,000 increase in salaries and benefits due expanded branch
operations compared to 2008 as well as expenses related to the 2008 Equity Incentive Plan.  OTS and FDIC assessments increased by $352,000 due to an industry-wide increase in assessment rates and a second quarter special assessment imposed by the FDIC in efforts to rebuild the Deposit Insurance Fund.  Occupancy expenses increased in the period primarily as a result of expenses associated with our new Port Angeles branch facility and the Tacoma branch facility acquired from 1st Security.  These
increases were partially offset by a $211,000 decrease in charitable contributions.  The charitable contributions from the prior period were primarily the result of our $200,000 charitable contribution to Sound Community Foundation (a non-stock Washington corporation we formed in connection with our stock offering).




Income Tax Expense (Benefit).  In the three month period ended September 30, 2009, we incurred an income tax expense of $13,000 on our pre-tax income as compared to an expense of $85,000 for the three month period ended September 30,
2008.




In the nine month period ended September 30, 2009, we incurred an income tax benefit of $162,000 on our pre-tax income as compared to an expense of $75,000 for the nine month period ended September 30, 2008.




Off-Balance Sheet Arrangements





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




A summary of our off-balance sheet commitments at September 30, 2009, is as follows:




Off-balance sheet loan commitments:Commitments to make loans

$
6,614,000Unfunded Letters of Credit


160,000Undisbursed portion of loans closed


3,184,000Unused lines of credit


30,573,000Total loan commitments

$
40,531,000










36





Liquidity




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




We maintain cash and investments that qualify as liquid assets to maintain liquidity to ensure safe and sound operation and meet demands for funds (particularly withdrawals of deposits).  At September 30, 2009, the Company had $49.2 million in cash and investment securities available for sale and $2.7 million
in loans held for sale generally available for its cash needs.  During the nine months ended September 30, 2009, we significantly increased our investment in agency securities in order to provide collateral for our growing public fund deposit balances as well as invest excess cash on hand as a result of the 1st Security transaction.  We also have access to additional funds through borrowings, primarily through credit lines at the FHLB, Federal Reserve discount window and the Pacific Coast
Bankers Bank.  At September 30, 2009, the Bank had the ability to borrow an additional $86.6 million from the Federal Home Loan Bank, $24.8 million from the Federal Reserve discount window, and $2.0 million from the Pacific Coast Bankers Bank, subject to certain collateral requirements.




At September 30, 2009, we had $40.5 million in outstanding loan commitments, including unused lines of credit and unfunded letters of credit.  Certificates of deposit scheduled to mature in one year or less at September 30, 2009, totaled $87.0 million.  It is management’s policy to maintain
deposit rates that are competitive with other local financial institutions.  Based on this management strategy and our own experience, we believe that a majority of maturing deposits will remain with the Bank.  We do not utilize wholesale or brokered deposits to meet our funding needs.  Please refer to our cash flow statement for additional information respecting our liquidity.




Capital




The Bank is subject to minimum capital requirements imposed by the Office of Thrift Supervision (“OTS”).  Based on its capital levels at September 30, 2009, the Bank exceeded these requirements as of that date and continues to exceed them as of the date of this filing.  Consistent with
our goals to operate a sound and profitable organization, our policy is for the Bank to maintain a “well-capitalized” status under the capital categories of the OTS.  Based on capital levels at September 30, 2009, the Bank was considered to be well-capitalized.  Management monitors the capital levels of the Bank to provide for current and future business opportunities and to meet regulatory guidelines for “well-capitalized” institutions.







37





The following table shows the capital ratios of the Bank at September 30, 2009:




Actual


For Capital
Adequacy Purposes


Minimum Required to
Be Well Capitalized
Under Prompt
Corrective
Action ProvisionsAmount


Ratio


Amount


Ratio


Amount


Ratio(Dollars in thousands)Risk-Based Capital(1)
(to risk-weighted assets)

$
27,881



11.49
%

$
19,415



8.00
%

$
24,269



10.00
%Core Capital(1)
(to risk-weighted assets)

$
25,354



10.45
%

$
9,708



4.00
%

$
14,561



6.00
%Core Capital(2)
(to total adjusted  assets)

$
25,354



7.14
%

$
14,195



4.00
%

$
17,743



5.00
%


____________


1.  Based on risk-weighted assets of $242,690 at September 30, 2009.


2.  Based on total adjusted assets of $354,865 at September 30, 2009.





Impact of Inflation




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




Item 3   Quantitative and Qualitative Disclosures About Market Risk





Not required; the Company is a smaller reporting company.




Item 4T Controls and Procedures





(a)  Evaluation of Disclosure Controls and Procedures





An evaluation of the Company's disclosure controls and procedures as defined in Rule 13a -15(e) under the Securities Exchange Act of 1934 (the "Act") as of September 30, 2009, was carried out under the supervision and with the participation of the Company's Chief Executive Officer, Chief Financial Officer and several
other members of the Company's senior management.  The Chief Executive Officer and Chief Financial Officer concluded that, as of September 30, 2009, the Company's disclosure controls and procedures were effective in ensuring that the information required to be disclosed by the Company in the reports it files or submits under the Act is: (i) accumulated and communicated to the Company's management (including the Chief Executive Officer and the Chief 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.





38





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




The Company does not expect that its disclosure controls and procedures will prevent all error and all fraud.  A control procedure, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control procedure are met.  Because of the
inherent limitations in all control procedures, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected.  These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake.  Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management
override of the control.  The design of any control procedure is also 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 and procedures may deteriorate.  Because of the inherent limitations in a cost-effective control
procedure, misstatements due to error or fraud may occur and not be detected.






(b)  Change in Internal Controls Over Financial Reporting




There were no changes in our internal control over financial reporting (as defined in Rule 13a - 15(f) under the Act) that occurred during the quarter ended September 30, 2009, that has materially affected, or is likely to materially affect our internal control over financial reporting.




PART II    OTHER INFORMATION




Item 1        Legal Proceedings





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





Item 1A      Risk Factors





Not required; the Company is a smaller reporting company.




Item 2         Unregistered Sales of Equity Securities and use of Proceeds





(a)           Recent Sales of Unregistered Securities





Nothing to report.





(b)           Use of Proceeds





Nothing to report.





39








(c)           Stock Repurchases





Nothing to report.





Item 3         Defaults Upon Senior Securities





Nothing to report.





Item 4         Submission of Matters to a Vote of Security Holders





Nothing to report.





Item 5.        Other Information





Nothing to report.








40





Item 6      Exhibits





Exhibit Number
Document
Reference to
Prior Filing
or Exhibit Number
Attached Hereto3.1
Charter for Sound Financial, Inc.
*3.2
Bylaws of Sound Financial, Inc.
**4
Form of Stock Certificate of Sound Financial, Inc.
**10.1
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 Community Incentive Compensation Achievement Plan
*10.5
Summary of Annual Bonus Plan
*10.6
Summary of Quarterly Bonus Plan
*10.7
Director Fee Arrangements for 2009
***10.8
Sound Financial, Inc. 2008 Equity Incentive Plan
***10.9
Form of Incentive Stock Option Agreement under the 2008 Equity Incentive Plan
+10.10
Form of Non-Qualified Stock Option Agreement under the 2008 Equity Incentive Plan
+10.11
Form of Restricted Stock Agreement under the 2008 Equity Incentive Plan
+10.12
Employment Agreements with executive officers Matthew Denies,
Matthew Moran, Scott Boyer and Marlene Price
++11
Statement re computation of per share earnings
None15
Letter re unaudited interim financial information
None18
Letter re change in accounting principles
None19
Reports furnished to security holders
None22
Published report regarding matters submitted to vote of security holders
None23
Consents
None24
Power of Attorney
None31.1
Rule 13a–14(a) Certification of Chief Executive Officer
31.131.2
Rule 13a–14(a) Certification of Chief Financial Officer
31.232
Section 1350 Certification
32   41
   Exhibit Number
Document
Reference to
Prior Filing
or Exhibit Number
Attached Hereto
  *
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.**
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.***
Filed as an exhibit to the Company’s Form 10-K filed on March 31, 2009.+
Filed as an exhibit to the Company’s Form 8-K filed on January 29. 2009.++
Filed as an exhibit to the Company’s Form 8-K filed on November 5, 2009.





42











SIGNATURES








Pursuant to the requirements 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 FINANICAL, INC.November 16, 2009

By:
/s/  Laura Lee StewartLaura Lee StewartPresident and Chief Executive OfficerNovember 16, 2009

By:
/s/  Matthew P. DeinesMatthew P. DeinesExecutive Vice PresidentChief Financial OfficerPrincipal Financial and Accounting Officer





43





Exhibit Index








31.1
Rule 13a–14(a) Certification of Chief Executive Officer
31.131.2
Rule 13a–14(a) Certification of Chief Financial Officer, Principal Financial and Accounting Principal
31.232
Section 1350 Certification
32