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 March 31,
2010





OR





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





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 of organization)
            
            (IRS
      Employer Identification No.)





2005 5thAvenue, Second Floor, Seattle, Washington 98121(Address
      of principal executive offices)





(206) 448-0884(Registrant’s
      telephone number)





None(Former
      name, former address and former fiscal year, if changed since last
      report)





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




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




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




Indicate by check mark
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 proceeding 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 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 May
17, 2010, there were issued and outstanding 3,000,095 shares of the registrant’s
common stock.








SOUND
FINANCIAL, INC.


FORM
10-Q


TABLE OF
CONTENTS





Page
      NumberPART
      IFINANCIAL
      INFORMATIONItem
      1.     Financial StatementsConsolidated Balance Sheets as
      of March 31, 2010 (unaudited) and December 31, 2009
            2Consolidated Statements of
      Income for the Three Months Ended March 31, 2010 and 2009
      (unaudited)
            3Consolidated Statements of
      Stockholders’ Equity for the Three Months Ended March 31, 2010
      (unaudited)
            4Consolidated
      Statement of Cash Flows For the Three Months Ended March 31, 2010 and 2009
      (unaudited)
            5Selected
      Notes to Consolidated Financial Statements
            6Item
      2.    Management's Discussion and Analysis of Financial
      Condition and Results of Operations
            19Item
      3.    Quantitative and Qualitative Disclosures About Market
      Risk
            25Item
      4.    Controls and Procedures
            25PART
      II   OTHER INFORMATIONItem
      1.     Legal Proceedings
            26Item
      1A    Risk Factors
            26Item
      2.    Unregistered Sales of Equity Securities and Use of
      Proceeds
            26Item
      3.    Defaults Upon Senior Securities
            27Item
      4.    Reserved
            27Item
      5.    Other Information
            27Item
      6.    Exhibits
            28SIGNATURESEXHIBITS











PART
I     FINANCIAL INFORMATION





Item
1       Financial Statements





SOUND
      FINANCIAL, INC AND SUBSIDIARYConsolidated
      Balance Sheets(unaudited)MARCH
      31,
              
              
              DECEMBER
      31,2010
              
              
              2009ASSETSCash
      and cash equivalents
              
              $
              5,657,989
              
              
              $
              15,678,766Securities
      available-for-sale (AFS), at fair value
              
              
              12,383,294
              
              
              
              9,899,092Federal
      Home Loan Bank (FHLB) stock, at cost
              
              
              2,444,000
              
              
              
              2,444,000Loans
      held for sale
              
              
              2,332,901
              
              
              
              2,857,700Loans
              
              
              297,347,144
              
              
              
              289,824,133Less
      allowance for loan losses
              
              
              (4,023,681
              )
              
              
              (3,467,567
              )Total
      loans, net
              
              
              293,323,463
              
              
              
              286,356,566Accrued
      interest receivable
              
              
              1,337,179
              
              
              
              1,305,590Premises
      and equipment, net
              
              
              3,421,615
              
              
              
              3,523,753Bank-owned
      life insurance
              
              
              6,528,892
              
              
              
              6,462,892Mortgage
      servicing rights, at fair value
              
              
              3,613,924
              
              
              
              2,017,489Mortgage
      servicing rights, at cost
              
              
              -
              
              
              
              1,309,809Other
      real estate owned and repossessed assets
              
              
              1,904,056
              
              
              
              1,383,638Other
      assets
              
              
              4,853,759
              
              
              
              4,566,464Total
      assets
              
              $
              337,801,072
              
              
              $
              337,805,759
  LIABILITIESDepositsInterest-bearing
              
              $
              262,873,142
              
              
              $
              266,337,202Noninterest-bearing
      demand
              
              
              25,058,232
              
              
              
              21,226,575Total
      deposits
              
              
              287,931,374
              
              
              
              287,563,777Borrowings
              
              
              20,000,000
              
              
              
              20,000,000Accrued
      interest payable
              
              
              138,247
              
              
              
              166,043Other
      liabilities
              
              
              3,891,309
              
              
              
              4,668,216Advance
      payments from borrowers for taxes and insurance
              
              
              572,279
              
              
              
              339,566Total
      liabilities
              
              
              312,533,209
              
              
              
              312,737,602COMMITMENTS
      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,
                3,000,095 issued and 2,954,295 outstanding as of March 31,
      2010
                and December 31, 2009
              
              
              30,001
              
              
              
              30,001Additional
      paid-in capital
              
              
              11,720,641
              
              
              
              11,687,641Unearned
      shares - Employee Stock Ownership Plan (“ESOP”)
              
              
              (924,480
              )
              
              
              (924,480
              )Retained
      earnings
              
              
              15,270,422
              
              
              
              15,214,549Accumulated
      other comprehensive loss, net of tax
              
              
              (828,721
              )
              
              
              (939,554
              )Total
      stockholders’ equity
              
              
              25,267,863
              
              
              
              25,068,157Total
      liabilities and stock holders’ equity
              
              $
              337,801,072
              
              
              $
              337,805,759








See notes to consolidated financial
statements


2


SOUND
FINANCIAL, INC. AND SUBSIDIARY


Consolidated
Statements of Income


(Unaudited)


THREE
      MONTHS ENDEDMARCH
      31,2010
            
            
            2009INTEREST
      INCOMELoans,
      including fees
            
            $
            4,592,243
            
            
            $
            4,354,335Interest
      and dividends on investments, cash and cash equivalents
            
            
            177,312
            
            
            
            183,267Total
      interest income
            
            
            4,769,555
            
            
            
            4,537,602INTEREST
      EXPENSEDeposits
            
            
            1,019,512
            
            
            
            1,655,966Other
      interest expense
            
            
            148,331
            
            
            
            251,707Total
      interest expense
            
            
            1,167,843
            
            
            
            1,907,673NET
      INTEREST INCOME
            
            
            3,601,712
            
            
            
            2,629,929PROVISION
      FOR LOAN LOSSES
            
            
            1,425,000
            
            
            
            450,000NET
      INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES
            
            
            2,176,712
            
            
            
            2,179,929NONINTEREST
      INCOMEService
      charges and fee income
            
            
            528,528
            
            
            
            513,356Earnings
      on cash surrender value of bank owned life insurance
            
            
            66,000
            
            
            
            66,000Mortgage
      servicing income
            
            
            164,902
            
            
            
            174,918Fair
      value adjustment on mortgage servicing rights
            
            
            285,003
            
            
            
            -Gain
      on sale of securities
            
            
            75,018
            
            
            
            -Loss
      on sale of assets
            
            
            (48,006
            )
            
            
            (192,864
            )Gain
      on sale of loans
            
            
            64,204
            
            
            
            23,984Total
      noninterest income
            
            
            1,135,649
            
            
            
            585,394NONINTEREST
      EXPENSESalaries
      and benefits
            
            
            1,616,898
            
            
            
            1,397,815Operations
            
            
            833,588
            
            
            
            765,311Regulatory
      assessments
            
            
            230,537
            
            
            
            61,619Occupancy
            
            
            381,187
            
            
            
            270,176Data
      processing
            
            
            200,148
            
            
            
            188,773Total
      noninterest expense
            
            
            3,262,358
            
            
            
            2,683,694INCOME  BEFORE
      PROVISION (BENEFIT)FOR
      INCOME TAXES
            
            
            50,003
            
            
            
            81,629PROVISION
      (BENEFIT) FOR INCOME TAXES
            
            
            (7,083
            )
            
            
            6,650NET
      INCOME
            
            $
            57,086
            
            
            $
            74,979BASIC
      EARNINGS PER SHARE
            
            $
            0.02
            
            
            $
            0.03DILUTED
      EARNINGS PER SHARE
            
            $
            0.02
            
            
            $
            0.03





See
notes to consolidated financial statements


3


SOUND
FINANCIAL, INC. AND SUBSIDIARY


Consolidated
Statement of Stockholders’ Equity


for the
Three Months Ended March 31, 2010 (unaudited)





Shares
            
            
            Common
              Stock
            
            
            Additional
              Paid-in
              Capital
            
            
            Unearned
              ESOP
              Shares
            
            
            Retained
      Earnings
            
            
            Accumulated
      Other Comprehensive Loss, net of tax
            
            
            Total
              Stockholders’
      EquityBALANCE,
      December 31, 2009
            
            
            2,954,295
            
            
            $
            30,001
            
            
            $
            11,687,641
            
            
            $
            (924,480
            )
            
            $
            15,214,549
            
            
            $
            (939,554
            )
            
            $
            25,068,157Adoption
      of fair value option on mortgage servicing rights, net of tax of
      $13,150
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            25,527
            
            
            
            
            
            
            
            25,527Other
      comprehensive income:Net
      income
            
            
            
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            57,086
            
            
            
            -
            
            
            
            57,086Net
      gain in fair value of investments available for sale, net of tax expense
      of $57,096
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            110,834
            
            
            
            110,834Total
      comprehensive income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            167,920Cash
      dividend declared and paid ($0.02 per share)
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (26,741
            )
            
            
            
            
            
            
            (26,741
            )Compensation
      related to stock options and restricted stock
            
            
            
            
            
            
            
            
            
            
            33,000
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            33,000BALANCE,
      March 31, 2010
            
            
            2,954,295
            
            
            $
            30,001
            
            
            $
            11,720,641
            
            
            $
            (924,480
            )
            
            $
            15,270,422
            
            
            $
            (828,721
            )
            
            $
            25,267,863







See
notes to consolidated financial statements


4


SOUND
FINANCIAL, INC. AND SUBSIDIARY


Consolidated
Statements of Cash Flows (unaudited)





Three
      Months Ended March 31,2010
            
            
            2009CASH
      FLOWS FROM OPERATING ACTIVITIESNet
      income (loss)
            
            $
            57,086
            
            
            $
            74,979Adjustments
      to reconcile net income (loss) to net cash from operating
      activitiesAccretion
      of net premium on investments
            
            
            (198,744
            )
            
            
            (33,627
            )Gain
      on sale of securities
            
            
            75,018
            
            
            
            -Provision
      for loan losses
            
            
            1,425,000
            
            
            
            450,000Depreciation
      and amortization
            
            
            166,492
            
            
            
            113,421Compensation
      expense related to stock options and restricted stock
            
            
            33,000
            
            
            
            30,000Fair
      value gain on mortgage servicing rights
            
            
            (285,003
            )
            
            
            -Additions
      to mortgage servicing rights
            
            
            (99,135
            )
            
            
            (211,609
            )Amortization
      of mortgage servicing rights
            
            
            136,189
            
            
            
            132,533Increase
      in cash surrender value of bank owned life insurance
            
            
            (66,000
            )
            
            
            (66,000
            )Proceeds
      from sale of loans
            
            
            9,942,908
            
            
            
            21,931,544Originations
      of loans held for sale
            
            
            (9,353,905
            )
            
            
            (25,175,465
            )Loss
      on sale of other real estate owned and repossessed assets
            
            
            48,804
            
            
            
            25,716Gain
      on sale of loans
            
            
            (64,204
            )
            
            
            (23,984
            )(Decrease)
      increase in operating assets and liabilitiesAccrued
      interest receivable
            
            
            (31,589
            )
            
            
            (135,512
            )Other
      assets
            
            
            (479,986
            )
            
            
            875,115Accrued
      interest payable
            
            
            (27,796
            )
            
            
            (7,743
            )Other
      liabilities
            
            
            (776,907
            )
            
            
            397,540Net
      cash from operating activities
            
            
            501,228
            
            
            
            (1,623,092
            )CASH
      FLOWS FROM INVESTING ACTIVITIESProceeds
      from maturities and sales of available for sale
investments
            
            
            3,761,671
            
            
            
            377,585Purchase
      of available for sale investments
            
            
            (5,831,773
            )
            
            
            (4,936,851
            )Net
      increase in loans
            
            
            (9,038,538
            )
            
            
            (2,643,270
            )Improvements
      to OREO and other repossessed assets
            
            
            -
            
            
            
            (15,345
            )Proceeds
      from sale of OREO and other repossessed assets
            
            
            77,420
            
            
            
            197,532Purchases
      of premises and equipment
            
            
            (64,354
            )
            
            
            (424,556
            )Net
      cash from investing activities
            
            
            (11,095,574
            )
            
            
            (7,444,905
            )CASH
      FLOWS FROM FINANCING ACTIVITIESNet
      increase in deposits, net of acquired deposits
            
            
            367,597
            
            
            
            27,057,585Proceeds
      from borrowings
            
            
            17,100,000
            
            
            
            -Repayment
      of borrowings
            
            
            (17,100,000
            )
            
            
            (17,219,355
            )Repurchase
      of common stock
            
            
            -
            
            
            
            (144,556
            )Cash
      dividends paid
            
            
            (26,741
            )
            
            
            (53,065
            )Net
      change in advances from borrowers for taxes and insurance
            
            
            232,713
            
            
            
            238,342Net
      cash from financing activities
            
            
            573,569
            
            
            
            9,878,951INCREASE
      (DECREASE) IN CASH AND CASH EQUIVALENTS
            
            
            (10,020,777
            )
            
            
            810,954CASH
      AND CASH EQUIVALENTS, beginning of period
            
            
            15,678,766
            
            
            
            5,607,800CASH
      AND CASH EQUIVALENTS, end of period
            
            $
            5,657,989
            
            
            $
            6,418,754SUPPLEMENTAL
      CASH FLOW INFORMATIONCash
      paid for income taxes
            
            $
            160,000
            
            
            $
            -Interest
      paid on deposits and borrowings
            
            $
            1,196,147
            
            
            $
            1,915,416Net
      transfer of loans to other real estate owned
            
            $
            646,642
            
            
            $
            629,283








See
notes to consolidated financial statements


5


SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statement (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, 2009, 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 April
2010, the Financial Accounting Standards Board (“FASB”) issued Accounting
Standards Update (“ASU”) No. 2010-18, Receivables (Topic 310): Effect of a Loan
Modification When the Loan Is Part of a Pool That Is Accounted for as a Single
Asset. This ASU codifies the consensus reached in Emerging Issues Task Force
(“EITF”) Issue No. 09-I, “Effect of a Loan Modification When the Loan Is Part of
a Pool That Is Accounted for as a Single Asset.” The amendments to the FASB
Accounting Standards CodificationTM (the “Codification” or “ASC”) provide that
modifications of loans that are accounted for within a pool under Subtopic
310-30 do not result in the removal of those loans from the pool even if the
modification of those loans would otherwise be considered a troubled debt
restructuring. An entity will continue to be required to consider whether the
pool of assets in which the loan is included is impaired if expected cash flows
for the pool change. ASU 2010-18 does not affect the accounting for loans under
the scope of Subtopic 310-30 that are not accounted for within pools. Loans
accounted for individually under Subtopic 310-30 continue to be subject to the
troubled debt restructuring accounting provisions within Subtopic
310-40.  ASU 2010-18 is effective prospectively for modifications of
loans accounted for within pools under Subtopic 310-30 occurring in the first
interim or annual period ending on or after July 15, 2010. Early application is
permitted. Upon initial adoption of ASU 2010-18, an entity may make a one-time
election to terminate accounting for loans as a pool under Subtopic 310-30. This
election may be applied on a pool-by-pool basis and does not preclude an entity
from applying pool accounting to subsequent acquisitions of loans with credit
deterioration. The Company does not expect this ASU to have an impact on our
consolidated financial statements.





In April,
2010, the FASB issued ASU No. 2010-13, Compensation—Stock Compensation (Topic
718): Effect of Denominating the Exercise Price of a Share-Based Payment Award
in the Currency of the Market in Which the Underlying Equity Security Trades.
The ASU codifies the consensus reached in EITF Issue No. 09-J. The amendments to
the Codification clarify that an employee share-based payment award with an
exercise price denominated in the currency of a market in which a substantial
portion of the entity’s equity shares trades should not be considered to contain
a condition that is not a market, performance, or service condition. Therefore,
an entity would not classify such an award as a liability if it otherwise
qualifies as equity. As the Company’s current share-based payment awards are
equity awards


6


SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements (unaudited)




(exercise
price is denominated in dollars in the U.S. where the Company’s stock is
traded), this ASU does not have an impact on our consolidated financial
statements.





In
February 2010, the FASB issued ASU No. 2010-09, Subsequent Events (Topic 855):
Amendments to Certain Recognition and Disclosure Requirements. The amendments in
this ASU remove the requirement for an SEC filer to disclose a date through
which subsequent events have been evaluated in both issued and revised financial
statements. Revised financial statements include financial statements revised as
a result of either correction of an error or retrospective application of U.S.
generally accepted accounting principles. The FASB believes these amendments
remove potential conflicts with the SEC’s literature. All of the amendments in
the ASU were effective upon issuance.





In
January 2010, the FASB issued ASU No. 2010-06, Fair Value Measurements and
Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements.
This ASU requires: (1) disclosure of the amounts of significant transfers in and
out of Level 1 and Level 2 fair value measurement categories and the reasons for
the transfers; and (2) separate presentation of purchases, sales, issuances, and
settlements in the reconciliation for fair value measurements using significant
unobservable inputs (Level 3). In addition, ASU 2010-06 clarifies the
requirements of the following existing disclosures set forth in the Codification
Subtopic 820-10: (1) For purposes of reporting fair value measurement for each
class of assets and liabilities, a reporting entity needs to use judgment in
determining the appropriate classes of assets and liabilities; and (2) a
reporting entity should provide disclosures about the valuation techniques and
inputs used to measure fair value for both recurring and non-recurring fair
value measurements. ASU 2010-06 is effective for interim and annual reporting
periods beginning January 1, 2010, except for the disclosures about purchases,
sales, issuances, and settlements in the roll forward of activity in Level 3
fair value measurements, which are effective for fiscal years beginning January
1, 2011, and for interim periods within those fiscal years. As ASU 2010-06 is
disclosure-related only, our adoption of this ASU in the first quarter of 2010
did not impact our consolidated financial statements.




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.





7


SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements (unaudited)





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:





Mortgage Servicing Rights -
The fair value of purchased mortgage servicing
rights is estimated using a discounted cash flow modelbased on market
information from a third party. These
assets are classified as Level 3.  At March 31, 2010, mortgage
servicing rights are carried at fair value.





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 March 31, 2010, loans held for sale were carried at
cost.





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.





8


SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements (unaudited)




The
following table presents the balances of assets measured at fair value on a
recurring basis at March 31, 2010:





Fair
      Value at March 31, 2010Description
            
            Total
            
            
            Level
      1
            
            
            Level
      2
            
            
            Level
      3Mortgage
      Servicing Rights
            
            $
            3,613,924
            
            
            $
            -
            
            
            $
            -
            
            
            $
            3,613,924Agency
      mortgage-backed securities
            
            
            7,500,793
            
            
            
            -
            
            
            
            7,500,793
            
            
            $
            -Non-agency
      mortgage-backed securities
            
            
            4,882,501
            
            
            
            -
            
            
            
            4,882,501
            
            
            $
            -Total
            
            $
            15,997,218
            
            
            $
            -
            
            
            $
            12,383,294
            
            
            $
            3,613,924





The
following table presents the balance of assets measured at fair value on a
nonrecurring basis at March 31, 2010, and the total losses resulting from these
fair value adjustments for the three months ended March 31, 2010:


Fair
      Value at March 31, 2010
              
              
              Three
      Months
                Ended
                March
      31, 2010Total
              
              
              Level
      1
              
              
              Level
      2
              
              
              Level
      3
              
              
              Total
      LossesDescriptionLoans
      Held for Sale
              
              $
              2,332,901
              
              
              
              -
              
              
              $
              2,332,901
              
              
              $
              -
              
              
              $
              -OREO
      and Repossessed Assets
              
              
              1,904,056
              
              
              
              -
              
              
              
              -
              
              
              
              1,904,056
              
              
              
              48,006Impaired
      Loans
              
              
              13,228,703
              
              
              
              -
              
              
              
              -
              
              
              
              13,228,703
              
              
              
              890,765Total
              
              $
              17,465,660
              
              
              
              -
              
              
              $
              2,332,901
              
              
              $
              15,132,759
              
              
              $
              938,771





There were
no liabilities carried at fair value, measured on a recurring or nonrecurring
basis, at March 31, 2010.





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 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 - 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 March 31, 2010, loans held for sale were carried at
cost.




9


SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements (unaudited)







Mortgage Servicing
Rights - The fair value of purchased
mortgage servicing rights is estimated using a discounted cash flow modelbased on market information from a third party. These assets are classified as Level
3.  At March 31, 2010, mortgage servicing rights are carried at fair
value.





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





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




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.




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




March
      31, 2010
            
            
            December
      31, 2009Carrying
            
            
            Fair
            
            
            Carrying
            
            
            FairAmount
            
            
            Value
            
            
            Amount
            
            
            ValueFinancial
      assets:Cash
      and cash equivalents
            
            $
            5,657,989
            
            
            $
            5,657,989
            
            
            $
            15,678,766
            
            
            $
            15,678,766AFS
      securities
            
            
            12,383,294
            
            
            
            12,383,294
            
            
            
            9,899,092
            
            
            
            9,899,092FHLB stock
            
            
            2,444,000
            
            
            
            2,444,000
            
            
            
            2,444,000
            
            
            
            2,444,000Loans
      held for sale
            
            
            2,332,901
            
            
            
            2,332,901
            
            
            
            2,857,700
            
            
            
            2,857,700Loans,
      net
            
            
            293,323,463
            
            
            
            294,146,214
            
            
            
            286,356,566
            
            
            
            286,430,669Accrued
      interest receivable
            
            
            1,337,179
            
            
            
            1,337,179
            
            
            
            1,305,590
            
            
            
            1,305,590Bank-owned
      life insurance
            
            
            6,528,892
            
            
            
            6,528,892
            
            
            
            6,462,892
            
            
            
            6,462,892Mortgage
      servicing rights, fair value
            
            
            3,613,924
            
            
            
            3,613,924
            
            
            
            2,017,489
            
            
            
            2,017,489Mortgage
      servicing rights, at cost
            
            
            -
            
            
            
            -
            
            
            
            1,309,809
            
            
            
            1,360,417Financial
      liabilities:Demand
      deposits
            
            $
            153,651,401
            
            
            $
            153,651,401
            
            
            $
            151,675,433
            
            
            $
            151,675,433Time
      deposits
            
            
            134,279,973
            
            
            
            136,913,380
            
            
            
            135,888,344
            
            
            
            137,833,241Borrowings
            
            
            20,000,000
            
            
            
            19,842,672
            
            
            
            20,000,000
            
            
            
            19,735,005Accrued
      interest payable
            
            
            138,247
            
            
            
            138,247
            
            
            
            166,043
            
            
            
            166,043Advance
      payments fromborrowers
      for taxes and insurance
            
            
            572,279
            
            
            
            572,279
            
            
            
            339,566
            
            
            
            339,566





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


10





SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements (unaudited)







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 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.





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 Company’s
membership interest in Visa, Inc.





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





As of March 31, 2010, 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 March 31, 2010, the value of
the Class A shares was $91.03 per share.  Using the new conversion
ratio, the value of unredeemed Class A equivalent shares owned by the Company
was $302,000, and has not been reflected in the accompanying financial
statements.






11






SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements (unaudited)







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





Note
6 – Loans





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


March
      31
                  2010
                
                
                December
      31,
                  2009
                
                
                Percentage
                  Increase/
                  (Decrease)Real
      estate loansOne-
      to four-family
                
                $
                104,895,376
                
                
                $
                104,460,367
                
                
                
                0.4
                %Home
      equity
                
                
                49,006,769
                
                
                
                50,444,530
                
                
                
                (2.9
                %)Commercial
                
                
                82,411,578
                
                
                
                72,035,266
                
                
                
                14.4
                %Construction
      or development
                
                
                9,313,351
                
                
                
                10,000,289
                
                
                
                (6.9
                %)245,627,074
                
                
                
                236,940,452
                
                
                
                3.7
                %Consumer
      loansManufactured
      homes
                
                
                20,802,939
                
                
                
                21,472,799
                
                
                
                (3.1
                %)Automobile
                
                
                5,683,341
                
                
                
                6,445,829
                
                
                
                (11.8
                %)Other
                
                
                8,584,480
                
                
                
                7,499,180
                
                
                
                14.5
                %35,070,760
                
                
                
                35,417,808
                
                
                
                (1.0
                %)Commercial
      business loans
                
                
                17,087,419
                
                
                
                17,799,946
                
                
                
                (4.0
                %)Total
      loans
                
                
                297,785,253
                
                
                
                290,158,206
                
                
                
                2.6
                %Deferred
      loan origination fees
                
                
                (438,109
                )
                
                
                (334,073
                )
                
                
                31.1
                %Allowance
      for loan losses
                
                
                (4,023,681
                )
                
                
                (3,467,567
                )
                
                
                16.0
                %Total
      loans, net
                
                $
                293,323,463
                
                
                $
                286,356,566
                
                
                
                2.4
                %




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




Three
      Months Ended March 31,2010
            
            
            2009Balance,
      beginning of year
            
            $
            3,467,567
            
            
            $
            1,305,950Provision
      for loan losses
            
            
            1,425,000
            
            
            
            450,000Recoveries
            
            
            21,879
            
            
            
            27,293Charge-offs
            
            
            (890,765
            )
            
            
            (310,909
            )Balance,
      end of year
            
            $
            4,023,681
            
            
            $
            1,472,334








12


SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements (unaudited)




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





March
      31
            
            
            December
      31,2010
            
            
            2009Impaired
      loans with a valuation allowance
            
            $
            10,018,124
            
            
            $
            4,125,169Valuation
      allowance related to impaired loans
            
            
            (1,442,012
            )
            
            
            (1,424,270
            )Impaired
      loans without a valuation allowance
            
            
            3,210,579
            
            
            
            9,019,027Total
      impaired loans, net of valuation allowance for impaired
    loans
            
            $
            11,786,691
            
            
            $
            11,719,926Total
      non-accrual loans
            
            
            3,515,000
            
            
            
            3,607,000Average
      investment in impaired loans
            
            
            3,448,000
            
            
            
            11,385,000Forgone
      interest on non-accrual loans
            
            
            62,000
            
            
            
            203,000Interest
      income recognized on impaired loans
            
            
            110,000
            
            
            
            -Troubled
      debt restructured loans
            
            
            9,874,000
            
            
            
            7,424,000





At March
31, 2010, there were no commitments to lend additional funds to borrowers whose
loans were classified as non-accrual or impaired.  At March 31, 2010
and December 31, 2009 there were no loans past due 90 days or more and still
accruing interest.




Note
7 – Investments




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




Gross
      UnrealizedAmortized
              Cost
            
            
            Gains
            
            
            Losses
      1 Year
              or
      Less
            
            
            Losses
      Greater
              Than
      1 Year
            
            
            Estimated
      Fair
              ValueMarch
      31, 2010Agency
      mortgage-backed securities
            
            $
            7,464,288
            
            
            $
            47,095
            
            
            $
            (10,590
            )
            
            $
            -
            
            
            $
            7,500,793Non-agency
      mortgage-backed securities
            
            
            6,113,421
            
            
            
            -
            
            
            
            -
            
            
            
            (1,230,920
            )
            
            
            4,882,501Total
            
            $
            13,577,709
            
            
            $
            47,095
            
            
            $
            (10,590
            )
            
            $
            (1,230,920
            )
            
            $
            12,383,294December
      31, 2009Agency
      mortgage-backed securities
            
            $
            3,421,392
            
            
            $
            5,415
            
            
            $
            (57,076
            )
            
            $
            -
            
            
            $
            3,369,731Non-agency
      mortgage-backed securities
            
            
            7,901,268
            
            
            
            120,866
            
            
            
            -
            
            
            
            (1,492,273
            )
            
            
            6,529,361Total
            
            $
            11,322,660
            
            
            $
            126,281
            
            
            $
            (57,076
            )
            
            $
            (1,492,773
            )
            
            $
            9,899,092




13




SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements (unaudited)




The
amortized cost and fair value of mortgage-backed securities by contractual
maturity, at March 31, 2010, are shown below.  Expected maturities of
mortgage-backed securities may differ from contractual maturities because
borrowers may have the right to call or prepay obligations with or without call
or prepayment penalties.





March
      31, 2010Amortized
      Cost
            
            
            Fair
      ValueDue
      within one year
            
            $
            -
            
            
            $
            -Due
      after one year through five years
            
            
            -
            
            
            
            -Due
      after five years through ten years
            
            
            -
            
            
            
            -Due
      after ten years
            
            
            13,577,709
            
            
            
            12,383,294$
            13,577,709
            
            
            $
            12,383,294





Securities
with an amortized cost and fair value of $2.2 million at March 31, 2010 were
pledged to secure Washington State Public Funds.





Other-Than-Temporary-Impairment





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





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





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





As of
March 31, 2010, our securities portfolio consisted of non-agency mortgage backed
securities with a fair value of $12.4 million, of which, $7.9 million, or eight
securities, were in an unrealized loss position.  The unrealized
losses on U.S. agency securities were caused by interest rate increases
subsequent to the purchase of these securities.  The unrealized losses
on non-U.S. agency securities were caused by changes in interest rates and
market illiquidity causing a decline in the fair value subsequent to the
purchase.  The contractual terms of these investments do not permit
the issuer to settle the securities at a price less than par. Because the Bank
does not intend to sell the securities and it is not likely that the Bank will
be required to sell these securities before recovery of the amortized cost
basis, which may include holding each security until contractual maturity, the
unrealized losses on these investments are not considered other-than-temporarily
impaired.





14





SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements (unaudited)






Note
8 – Mortgage Servicing Rights




On January 1, 2010, the Company
elected to adopt ASC
860-50-50-3 Servicing Assets and Liabilities, for all mortgage servicing
rights using the fair value measurement method. Management believes that this
method better represents the ongoing market value of the servicing
asset.  In addition to this factor, the Company was
previously carrying its acquired mortgage servicing rights portfolio at market
value and management believes that it will be more consistent to report all
mortgage servicing assets under the same method.




The changes in the mortgage servicing
asset is summarized below:




Beginning
      balance as of January 1, 2010
            
            $
            3,327,298Adoption
      of fair value option on mortgage servicing rights
            
            
            38,677Fair
      Value as of January 1, 2010
            
            
            3,365,975Additions:Servicing
      obligations that result from transfers of financial assets
            
            
            99,135Subtractions:Disposals
      of servicing obligations
            
            
            (136,189
            )Other
      changes in Fair Value
            
            
            285,003Fair
      Value as of March 31, 2010
            
            $
            3,613,924







Note
9 – Borrowings




The Company utilizes a loan agreement
with the FHLB of Seattle. The terms of the agreement call for a blanket pledge
of a portion of the Company’s mortgage and commercial real estate portfolio
based on the outstanding balance. At March 31, 2010, the amount available to
borrow under this agreement is approximately 35% of total assets, or up to
$118.2 million subject to the availability of eligible collateral. The Company
had outstanding borrowings under this arrangement of $20.0 million at March 31,
2010 and December 31, 2009.




The Company participates in the Federal
Reserve Bank’s Borrower-in-Custody program, which gives the Company access to
the discount window.  The terms of the program call for a pledge of
specific assets.  The Company had unused borrowing capacity of $19.0
million and $17.0 million at March 31, 2010 and December 31, 2009,
respectively.  There were no outstanding borrowings at March 31, 2010
or December 31, 2009.





The
Company has access to an unsecured line of credit from the Pacific Coast
Banker’s Bank.  This line of credit is equal to $2.0 million as of
March 31, 2010.  The line has a one-year term and is
renewable.  There was no outstanding balance on this line of credit as
of March 31, 2010 and December 31, 2009.


15


SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements (unaudited)






Note
10 – Earnings (loss) Per Share





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





Three
      months ended March 31,2010
            
            
            2009Net
      income (loss)
            
            $
            57,086
            
            
            $
            74,979Weighted
      average number of shares outstanding, basic
            
            
            2,909,072
            
            
            
            2,894,540Effect
      of dilutive stock options
            
            
            -
            
            
            
            -Weighted
      average number of shares outstanding, diluted
            
            
            2,909,072
            
            
            
            2,894,540Earnings
      per share, basic
            
            $
            0.02
            
            
            $
            0.03Earnings
      per share, diluted
            
            $
            0.02
            
            
            $
            0.03





For the
three month period ended March 31, 2009, there were no non-dilutive securities
included in the calculation for earnings per share.




Note
11 – Stock-based Compensation




Stock
Options and Restricted Stock





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




On January 27, 2009, the Compensation
Committee of the Board of Directors of the Company awarded shares of restricted
stock and stock options to directors, executive officers and employees of the
Company, and its wholly owned subsidiary, Sound Community Bank, pursuant to the
Plan. The Company granted 25,998 non-qualified stock options and 82,400
incentive stock options to certain directors and employees.  The
Company also granted 52,032 shares of restricted stock to certain directors and
employees. During the period ended March 31, 2010, share based compensation
expense totaled $33,000.







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




There
were 21,680 exercisable stock options as of March 31, 2010. The aggregate
intrinsic value of the stock options as of March 31, 2010 was
$0.


16


SOUND
FINANCIAL, INC. AND SUBSIDIARY


Notes to
Consolidated Financial Statements (unaudited)




The
following is a summary of the Company’s stock option plan awards during the
period ended March 31, 2010:





Shares
            
            
            Weighted-Average
      Exercise Price
            
            
            Weighted-Average
      Remaining Contractual Term In Years
            
            
            Aggregate
      Intrinsic ValueOutstanding
      at the beginning of the year
            
            
            108,398
            
            
            $
            7.93Granted
            
            
            -
            
            
            
            -Exercised
            
            
            -
            
            
            
            -Forfeited
      or expired
            
            
            -
            
            
            
            -Outstanding
      at March 31, 2010
            
            
            108,398
            
            
            $
            7.93
            
            
            
            8.84
            
            
            $
            -Expected
      to vest, assuming a
              0%
      forfeiture rate over the
              vesting
      term
            
            
            108,398
            
            
            $
            7.93
            
            
            
            8.84
            
            
            $
            -





As of
March 31, 2010, there was $213,000 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 3.84 years.





Restricted
Stock Awards





The fair
value of the restricted stock awards is equal to the fair value of the Company’s
stock at the date of grant. Compensation expense is recognized over the
vesting period that the awards are based. Shares awarded as restricted
stock vest ratably over a five-year period beginning at the grant date with 20%
vesting on the anniversary date of each grant date. In November 2008, the Board
of Directors authorized management to repurchase up to 57,782 shares of the
Company’s outstanding stock over a twelve-month period in order to fund the
restricted stock awards made under the Plan. As of March 31, 2010, 45,800 shares
have been repurchased under the Plan.





The
following is a summary of the Company’s nonvested restricted stock awards for
the period ended March 31, 2010:


Nonvested Shares
            
            Shares
            
            
            Weighted-Average
      Grant-Date Fair Value
            
            
            Aggregate
      Intrinsic ValueNonvested
      at January 1, 2010
            
            
            52,032
            
            
            $
            7.35Granted
            
            
            -
            
            
            
            -Vested
            
            
            10,406
            
            
            
            -Forfeited
            
            
            -
            
            
            
            -Nonvested
      at March 31, 2009
            
            
            41,626
            
            
            $
            7.35
            
            
            $
            4.50-Expected
      to vest assuming a 0%
              forfeiture
      rate over the vesting term
            
            
            41,626
            
            
            $
            7.35
            
            
            $
            4.50





17


SOUND
FINANCIAL, INC. AND SUBSIDIARY.


Notes to
Consolidated Financial Statements (unaudited)







The
aggregate intrinsic value of the restricted stock options as of March 31, 2010
was $187,000.





As of March 31, 2010, $294,000 of
unrecognized compensation cost related to non-vested restricted stock granted
under Plan remained.  The cost is expected to be recognized over the
weighted-average vesting period of 3.84 years.





Employee
Stock Ownership Plan





In January 2008, the ESOP borrowed
$1,155,600 from the Company to purchase common stock of the Company. The loan is
being repaid principally from the Company’s contributions to the ESOP over a
period of ten years. The interest rate on the loan is fixed at 4.0% per
annum.  As of March 31, 2010, the remaining balance of the ESOP loan
was $962,000.  Neither the loan nor the related interest is reflected
on the consolidated financial statements.





At March
31, 2010, the ESOP was committed to release 11,556 shares of the Company’s
common stock to participants and held 92,448 unallocated shares remaining to be
released in future years.  The fair value of the 92,448 restricted
shares held by the ESOP trust was $416,000 at March 31, 2010.  ESOP
compensation expense included in salaries and benefits was $17,000 for the
period ended March 31, 2010.











18





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





Forward-Looking
Statements





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





General




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




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




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




Substantially
all of Sound Financial’s business is conducted through the Bank, which is a
federal savings bank subject to extensive regulation by the
OTS.  Sound Community Bank’s deposits are insured up to applicable
limits by the Federal Deposit Insurance Corporation (“FDIC”).  At
March 31, 2010, we had total consolidated assets of $337.8 million, deposits of
$287.9 million and stockholders’ equity of $25.3 million.  The shares
of Sound Financial are traded on the Over-the-Counter Electronic
Bulletin




19


Board
under the symbol “SNFL.”  Our executive offices are located at 2005
5th
Avenue – Suite 200, Seattle, Washington, 98121.




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




The
Company’s principal business consists of attracting retail and small business
deposits from the general public and investing those funds, along with borrowed
funds, in loans secured by first and second mortgages on one- to four-family
residences (including home equity loans and lines of credit), commercial real
estate, consumer and commercial business loans and, to a lesser extent,
construction and development loans.  We offer a wide variety of
secured and unsecured consumer loan products, including manufactured home loans,
automobile loans, boat loans and recreational vehicle loans.  We
intend to continue emphasizing our residential mortgage, home equity and
consumer lending, while also expanding our emphasis in commercial real estate
and commercial business lending.  In recent years, we have focused on
expanding our commercial loan portfolio (commercial real estate and other
commercial loans), which has grown to $101.7 million or 34.2% of our loan
portfolio at March 31, 2010, from $77.2 million or 28.1% of our loan portfolio
at March 31, 2009.




As part
of our business, we focus on mortgage loan originations, many of which we sell
to Fannie Mae.  We sell these loans with servicing retained to
maintain the direct customer relationship and support our emphasis on strong
customer service.  We originated $16.0 million and $25.2 million in
one- to four-family residential mortgage loans during the three month periods
ended March 31, 2010 and 2009, respectively.  During these same
periods, we sold $9.8 million and $22.0 million, respectively, of one- to
four-family residential mortgage loans.




We offer
a variety of deposit accounts, which are our primary source of funding for our
lending activities.  In recent years we have also relied on Federal
Home Loan Bank advances to augment our deposits and fund the growth of interest
earning assets.




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




During
2009, the Company expanded its operations through the acquisition of two
branches in Port Angeles and Tacoma, Washington.  In July 2009, the
Company opened a new branch in Port Angeles.  On September 1, 2009,
the Company acquired the Port Angeles and Tacoma offices of 1st Security Bank,
including $33.6 million in deposits.  The operations of the Port
Angeles location were moved to the Company’s new Port Angeles branch, and the
1st
Security Bank branch location was vacated.  The Company’s former
branch in Lakewood was closed and the operations were consolidated with the
leased 1st
Security branch in Tacoma.  On March 31, 2010, the Company’s branch in
Tukwila was closed and the operations were consolidated with the downtown
Seattle branch.


20


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 tax asset
accounts are described in our Form 10-K Annual Report for the year ended
December 31, 2009.




Comparison
of Financial Condition at March 31, 2010 and December 31, 2009




General.  Total assets
decreased by $5,000 in the period to $337.8 million at March 31,
2010.  The limited overall change was primarily the result of a $10.0 million, or
63.9%, decrease in cash and cash equivalents which was offset by a $7.0 million
increase in our loan portfolio, including loans held for sale, from $286.4
million at December 31, 2009 to $293.3 million at March 31, 2010 and the
purchase of agency mortgage-backed securities, which increased by $2.5 million
or 20.1%, from $9.9 million at December 31, 2009 to $12.4 million at March 31,
2010.




Loans.  Our
loan portfolio increased $7.0 million, or 2.4%, to $293.3 million at March
31, 2010, from $286.4 million at December 31, 2009.  The
changes in our net loan portfolio are reflected in Note 6 to our financial
statements above.  The most significant changes include a 14.4%
increase in commercial real estate loans, a 14.5% increase in other
consumer loans and an11.8% decrease in auto loans.  The increase in commercial
real estate loans during the three months ended March 31, 2010 is consistent
with our strategy to diversify our loan portfolio and increase the amount of
generally higher-yielding commercial loans in our portfolio.  The
increase in other consumer loans is primarily a result of a houseboat loan
closed in the first quarter.  The decrease in auto loan demand is
primarily a result of the general state of the economy which is negatively
impacting auto sales coupled with aggressively subsidized rates currently
offered by auto manufacturers.




Allowance for
Loan Losses.  Our allowance for loan losses at March 31, 2010,
was $4.0 million, or 1.37%, of netloansreceivable, compared
to $3.5 million, or 1.21%, of netloansreceivable at
December 31, 2009.  The increase in the
allowance for loan losses was the result ofa $1,425,000 provision for
loan losses recorded during the three months ended March 31, 2010, partially offset by
net charge-offs of non-performing loans totaling$891,000.  This provision was primarily made as a result of
increases in our commercial loan portfolio in the 2010 period, as compared to
the 2009 period, an increase in our specifically impaired loans and an
evaluation of prevailing housing and other market
conditions.  Non-performing loans decreased to $3.5 million at March
31, 2010, from $3.6 million at December 31, 2009.  Non-performing
loans to total loans decreased to 1.18% at March 31, 2010, from 1.25% at
December 31, 2009.  Other real estate owned increased by $520,000, or
37.6% to $1.9 million at March 31, 2010, compared to $1.4 million as of December
31, 2009.  This increase is a result of five additional properties
taken back by the Bank in the quarter and the sale of three previously held
properties.  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
decreased by $10.0 million, or 63.9%, to $5.7 million at March 31,
2010.  Our securities portfolio consists of 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 $2.5
million, or 20.1%, to $12.4 million at March 31, 2010 from $9.9 million at
December 31, 2009.  This increase reflects the purchase of agency
mortgage-backed securities.




21


Included
in our investment portfolio are $4.9 million in non-agency mortgage-backed
securities.  These securities present a level of credit risk that does
not exist currently with agency backed securities which are guaranteed by the
United States government. In order to monitor the risk of these securities,
management receives a credit surveillance report which considers various factors
for each security including original credit scores, loan to value, geography,
delinquency and loss history.  The report also evaluates the
underlying loans within the security to project future losses based on various
home price depreciation scenarios over a three year horizon.  Based on
this analysis, management does not expect to incur any principal loss on any of
these investments as of March 31, 2010.




Deposits.  Total
deposits increased by $368,000, or 0.13%, to $287.9 million at March 31, 2010,
from $287.6 million at December 31, 2009.  Decreases in time deposits,
money market accounts, and interest-bearing and noninterest-bearing checking
accounts were offset by increases in savings and escrow accounts.  The
$3.3 million or 333.0% increase in escrow accounts were primarily a result of
the purchase of a servicing portfolio from Leader financial in the fourth
quarter of 2009. The decrease in time deposits and other interest-bearing
accounts reflects a bank-wide emphasis to generate additional low-cost
deposits.




Borrowings.  Federal
Home Loan Bank advances remained constant at $20.0 million at March 31,
2010.  The weighted average cost of borrowings as of March 31, 2010
was 2.87%, compared to our weighted average cost of deposits was 1.34% at that
date.




Equity.  Total
equity increased $200,000, or 0.80%, to $25.3
million at March 31, 2010, from $25.1 million at December 31,
2009.  This reflects a $111,000 decrease in accumulated other
comprehensive loss, $58,000 in earnings, $33,000 in stock compensation expense,
$27,000 in dividends and a $26,000 adjustment to equity due to the adoption of
fair value accounting for mortgage servicing rights.




Comparison
of Results of Operation for the Three Months Ended March 31, 2010 and
2009




General.  Net
income decreased $18,000 to $57,000 for the three months ended March 31, 2010,
compared to $75,000 for the three months ended March 31, 2009.  Higher
interest and non-interest income and lower interest expense was offset by
increases in the provision for loan losses and higher non-interest
expense.




Interest
Income.  Interest income increased by $232,000, or 5.1 %, to
$4.8 million for the three months ended March 31, 2009 from $4.5 million for the
three months ended March 31, 2009.  The increase in interest income
for the period reflects higher overall loan balances, particularly an increase
in the amount of commercial loans at generally higher rates.




The
weighted average yield on loans decreased to 6.28% for the three months ended
March 31, 2010, from 6.33% for the three months ended March 31,
2009.  The decrease was primarily the result of overall decreases in
the rate environment, which include record lows in the prime interest rate and
the 1-year Treasury bill rate, which we use to set and adjust rates for certain
variable rate loans.  We anticipate our weighted average yield on
loans will improve as we continue to emphasize higher yielding commercial real
estate and business loans. However, this improvement will also depend on the
overall rate environment and our ability to manage credit risk.




Interest
Expense.  Interest expense decreased $740,000, or 38.8%, to
$1.2 million for the three months ended March 31, 2009, from $1.9 million for
the three months ended March 31, 2009.  The decrease for the period
resulted primarily from the lower interest rates paid on repricing deposits and
FHLB advances as a result of the continued low interest rate
environment.  Our weighted average cost of interest-bearing
liabilities was 1.63% for the three months ended March 31, 2010, compared to
2.86% for the same period in 2009.




22


Interest
paid on deposits decreased $636,000, or 38.4%, to $1.0 million for the three
months ended March 31, 2010, as compared to $1.7 million for the three months
ended March 31, 2009.  The decrease for the three month period
resulted primarily from a decrease in the weighted average cost of deposits. We
experienced a 134 basis point decrease in the average rate paid on deposits
during the three months ended March 31, 2010, compared to the same period in
2009, from 2.77% to 1.43%, respectively.  This decrease in average
rates was a result of the repricing of matured certificates of deposit 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 $103,000, or 41.1%, to $148,000 for the three
months ended March 31, 2010 from $252,000 for the three months ended March 31,
2009.  The decrease resulted from a decrease in the average balance of
outstanding borrowings of $6.8 million, to $20.7 million for the three months
ended March 31, 2010, from $27.5 million for the three months ended March 31,
2009 coupled with a lower weighted average cost of borrowings during the 2010
period.




Net Interest
Income.  Net interest income increased $972,000, or 37.0%, to
$3.6 million for the three months ended March 31, 2010, from $2.6 million for
the three months ended March 31, 2009.  The increase in net interest
income for the three-month period primarily resulted from higher yields earned
on our expanding commercial loan portfolio and decreased interest expense on
deposits and borrowings as a result of the falling interest rate
environment.Our net interest margin was 4.65% for the three
months ended March 31, 2010,which is an increase from the 3.75% for the three
months ended March 31, 2009.




Provision for
Loan Losses.  We establish provisions for loan losses, which
are charged to earnings, at a level required to reflect management’s best
estimate of the probable incurred credit losses in the loan
portfolio.  In evaluating the level of the allowance for loan losses,
management considers historical loss experience, the types of loans and the
amount of loans in the loan portfolio, adverse situations that may affect
borrowers’ ability to repay, estimated value of any underlying collateral, peer
group data, prevailing economic conditions, and other 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 $1.4 million was made during the three months ended
March 31, 2010, compared to provision of $450,000 during the three months ended
March 31, 2009.  The higher provision was primarily attributable
toincreases in net
charge-offs, increases in our commercial loan portfolio, an increase in
our overall loan portfolio and continuing declines in market conditions in the
areas where we do business.




At March
31, 2010, the annualized ratio of net charge-offs to average loans increased 17
basis points to 0.67% from 0.50% at March 31, 2009.  The ratio of
non-performing loans to total loans increased from 0.30% at March 31, 2009 to
0.82% at March 31, 2010.




Noninterest
Income.  Noninterest income increased $550,000, or 94.0%, to
$1.1 million for the three months ended March 31, 2010, from $585,000 for the
three months ended March 31, 2009.  The primary reasons for this
increase was an increase in mortgage servicing income due to organic
growth of our servicing portfolio and the purchase of a servicing portfolio in
2009 as well as a $285,000 fair value adjustment to mortgage servicing
rights.  Other significant increases in noninterest income included a
$145,000 reduction in the loss on sale of assets, a $75,000 increase in gain on
sale of investments and a $40,000 increase in gain on the sale of loans sold to
Fannie Mae.




23


Noninterest
Expense.  Noninterest expense increased $579,000, or 21.6%, to
$3.3 million for the three months ended March 31, 2010, compared to $2.7 million
for the three months ended March 31, 2009.  The increase in the period
was primarily the result of an increase in salaries and benefits of $219,000 due
to staffing increases compared to the 2009 period.  Additional
increases include a $169,000 increase in FDIC and OTS regulatory expenses, an
$111,000 increase in occupancy expenses and a $68,000 increase in operations
expense.  The increases in regulatory expenses are a result in
increases in FDIC insurance charges and OTS assessments consistent in the
banking industry.  The increases in salaries, operations and occupancy
expenses are primarily a result of expanded operations in Tacoma and Port
Angeles as well as additions to our commercial lending group.




Income Tax
Expense (Benefit).  For the three months ended March 31, 2010,
we incurred an income tax benefit of $7,000 on our pre-tax income as compared to
an income tax expense of $7,000 for the three month period ended March 31,
2009.




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 to extend credit at March 31, 2010, is as follows:




Off-balance sheet loan
      commitments:Commitments
      to make
      loans
            
            $
            3,517,000Undisbursed
      portion of loans closed
            
            
            3,071,000Unused
      lines of
      credit
            
            
            29,865,000Irrevocable
      letters of
      credit
            
            
            265,000Total
      loan
      commitments
            
            $
            36,718,000





Liquidity




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




We
maintain cash and investments that qualify as liquid assets to maintain adequate
liquidity to ensure safe and sound operation and meet demands for funds
(particularly withdrawals of deposits).  At March 31, 2010, the
Company had $18.0 million in cash and investment securities available for sale
and $2.3 million in loans held for sale which are generally available for its
short-term cash needs.  We can also generate funds from borrowings,
primarily FHLB.  At March 31, 2010, the Bank had the ability to borrow
an additional $86.5 million in FHLB advances.




At March 31, 2010, we had $36.7 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 March 31, 2010, totaled $93.5 million and have a weighted
average cost of 2.3%.  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




24


deposits
will remain with the Bank.  We do not utilize wholesale or brokered
deposits to meet our funding needs.  For additional information on
liquidity refer to the statement of cash flows.




Capital




The Bank
is subject to minimum capital requirements imposed by the Office of Thrift
Supervision (“OTS”).  Based on its capital levels at March 31, 2010,
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 March 31, 2010, the Bank was
considered to be well-capitalized.  Management monitors the capital
levels of the Bank to provide for current and future business opportunities and
to meet regulatory guidelines for “well-capitalized” institutions.




The
following table shows the capital ratios of the Bank at March 31,
2010:




Actual
            
            
            Minimum Capital
                Requirements
            
            
            Minimum Required to
                Be Well-Capitalized
                Under Prompt
                Corrective
                Action
      ProvisionsAmount
            
            
            Ratio
            
            
            Amount
            
            
            Ratio
            
            
            Amount
            
            
            Ratio(Dollars
      in thousands)Tier 1 Capital
      to total adjusted assets
            
            $
            25,212
            
            
            
            7.45
            %
            
            $
            13,545
            
            
            
            4.00
            %
            
            $
            16,932
            
            
            
            5.00
            %Tier 1 Capital to
      risk-weighted assets
            
            $
            25,212
            
            
            
            10.09
            %
            
            $
            9,996
            
            
            
            4.00
            %
            
            $
            14,994
            
            
            
            6.00
            %Total Capital
      to risk-weighted assets
            
            $
            28,344
            
            
            
            11.34
            %
            
            $
            19,991
            
            
            
            8.00
            %
            
            $
            24,989
            
            
            
            10.00
            %


____________


1.  Based
on risk-weighted assets of $249,893 at March 31, 2010.


2.  Based
on total adjusted assets of $338,630 at March 31, 2010.





Item
3   Quantitative and Qualitative Disclosures About Market
Risk





Not
required; the Company is a smaller reporting company.




Item
4   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
March 31, 2010, 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 March 31, 2010, 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.




We intend
to continually review and evaluate the design and effectiveness of the Company’s
disclosure controls and procedures and to improve the Company’s controls and
procedures over time and




25




to
correct any deficiencies that we may discover in the future. The goal is to
ensure that senior management has timely access to all material financial and
non-financial information concerning the Company's business. While we believe
the present design of the disclosure controls and procedures is effective to
achieve this goal, future events affecting our 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)
            Changes
      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 March 31,
2010, 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.





(c)           Stock
Repurchases


26


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





There
were no shares repurchased under this repurchase plan during the first quarter
of 2010.





Item
3    Defaults Upon Senior Securities





Nothing
to report.





Item
4    Reserved





Nothing
to report.





Item
5.   Other Information





Nothing
to report.


27


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
            None18.1
            Letter
      re change in accounting principles
            18.119
            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





*
            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.+++
            Filed
      as an exhibit to the Company’s Form 10-Q filed on May 17,
      2010.





28


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.May
      17, 2010
            
            By:
            /s/  Laura Lee
      StewartLaura
      Lee StewartPresident
      and Chief Executive OfficerMay
      17, 2010
            
            By:
            /s/  Matthew P.
      DeinesMatthew
      P. DeinesExecutive
      Vice PresidentChief
      Financial OfficerPrincipal
      Financial and Accounting Officer








29


Exhibit
Index








18.1
            Letter
      re change in accounting principles
            18.131.1
            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


30