**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**









**FORM
      10-Q**





**x**
            **QUARTERLY
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES**


**EXCHANGE
      ACT OF 1934**





For
      the
      Quarterly Period Ended September 30, 2008





**OR**





**o**
            **TRANSITION
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES**


**EXCHANGE
      ACT OF 1934**





For
      the
      transition period from ________ to ________





Commission
      file number 333-106501





**KH
      FUNDING COMPANY**


(Exact
      name of registrant as specified in its charter)





Maryland
            
            52-1886133(State
                or Other Jurisdiction of
            
            (I.R.S.
                EmployerIncorporation
                or Organization)
            
            Identification
                No.)10801
                Lockwood Drive, Suite 370, Silver Spring, Maryland
            
            20901(Address
                of Principal Executive Offices)
            
            (Zip
                Code)





(301)
      592-8100


Registrant’s
      Telephone Number, Including Area Code





N/A





Former
      name, former address and former fiscal year, if changed since last
      report.





Indicate
      by check mark whether the registrant (1) has filed all reports required to
      be
      filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
      the
      preceding 12 months (or for such shorter periods 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 o





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
      the definitions of “large accelerated filer”, “accelerated filer” and “smaller
      reporting company” in Rule 12b-2 of the Exchange Act. (Check one):





Large
                accelerated filero
            Accelerated
                fileroNon-accelerated
                filero
            Smaller
                reporting companyx


(Do
      not
      check if a smaller reporting company)





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





**APPLICABLE
      ONLY TO CORPORATE ISSUERS**





Indicate
      the number of shares outstanding of each of the issuer’s classes of common
      stock, as of the latest practicable date: 2,574,981 shares, par value $.01
      per
      share, of common stock outstanding as of September 30, 2008.





**INDEX**





**Page**Part
                I. Financial Information
            
            
            3Item
                1. Financial Statements
            
            
            3Balance
                Sheets -September
                30, 2008 (unaudited) and December 31, 2007
            
            
            3Statements
                of Operations (unaudited) -For
                the three and nine months ended September 30, 2008 and
                2007
            
            
            4Statements
                of Changes in Stockholders’ Equity (unaudited) -For
                the nine months ended September 30, 2008 and 2007
            
            
            5Statements
                of Cash Flows (unaudited) -For
                the nine months ended September 30, 2008 and 2007
            
            
            6Notes
                to Interim Financial Statements (unaudited)
            
            
            7Item
                2. Management’s Discussion and Analysis of Financial Condition and Results
                of Operations
            
            
            13Item
                4T. Controls and Procedures
            
            
            20Part
                II. Other Information
            
            
            21Item
                1. Legal Proceedings
            
            
            21Item
                6. Exhibits
            
            
            21Signatures
            
            
            21Exhibit
                Index
            
            
            22


-2-


**PART
      I - FINANCIAL INFORMATION**





**Item
      1. Financial Statements.**





**KH
      FUNDING COMPANY**


**BALANCE
      SHEETS**





**September 30,**
              **2008**
            
            **December 31,**
              **2007****(unaudited)****Assets**Cash
            
            $
            12,366
            
            $
            95,622Investments
                available for sale:Stock
                in closely-held corporation
            
            
            25,437
            
            
            25,437Loans
                receivable, less allowance for loan losses of $660,424 (September
                30,
                2008) and $495,480 (December 31, 2007)
            
            
            41,942,780
            
            
            47,885,188Accrued
                interest receivable
            
            
            2,006,153
            
            
            2,668,649Other
                receivables
            
            
            243,130
            
            
            106,944Prepaid
                expenses
            
            
            187,949
            
            
            208,549Property
                and equipment – Net
            
            
            111,001
            
            
            141,993Real
                estate owned:Rental
                property
            
            
            1,362,201
            
            
            675,914Held
                for sale
            
            
            1,852,923
            
            
            1,568,655Other
                assets
            
            
            15,988
            
            
            15,988**Total
                Assets**
            
            $
            47,759,928
            
            $
            53,392,939**Liabilities
                and Stockholders’ Equity****Liabilities**Notes
                and accrued interest payable
            
            $
            40,684,175
            
            $
            51,219,963Other
                loans payable
            
            
            1,550,887
            
            
            702,094Accounts
                payable and accrued expenses
            
            
            37,025
            
            
            32,827Escrows
                and security deposits
            
            
            103,496
            
            
            101,383Long-term
                liabilities
            
            
            43,728
            
            
            35,842Participation
                loans
            
            
            5,065,822
            
            
            261,764**Total
                Liabilities**
            
            
            47,485,133
            
            
            52,353,873**Stockholders’
                Equity**Common
                stock (5,000,000 shares authorized; 2,574,981 shares (September 30,
                2008)
                and 2,724,981 shares (December 31, 2007) issued and outstanding,
                $0.01 par
                value)
            
            
            25,750
            
            
            27,250Paid-in
                capital
            
            
            1,442,984
            
            
            1,730,911Accumulated
                deficit
            
            
            (1,008,489
            )
            
            (533,645
            )Subscription
                note receivable
            
            
            (185,450
            )
            
            (185,450
            )**Total
                Stockholders’ Equity**
            
            
            274,795
            
            
            1,039,066**Total
                Liabilities and Stockholders’ Equity**
            
            $
            47,759,928
            
            $
            53,392,939





*The
      accompanying notes are an integral part of these
      statements.*


-3-


**KH
      FUNDING COMPANY**


**STATEMENTS
      OF OPERATIONS (UNAUDITED)**





**For the Three**
              **Months**
              **Ended September 30,**
            
            **For the Nine**
              **Months**
              **Ended September 30,****2008**
            
            **2007**
            
            **2008**
            
            **2007****Interest
                Income**Interest
                and fees on loans
            
            $
            989,599
            
            $
            1,489,711
            
            $
            3,256,046
            
            $
            4,537,769Interest
                on bank accounts
            
            
            30
            
            
            48
            
            
            108
            
            
            5,759Interest
                on investments —marketable securities
            
            
            -
            
            
            6,539
            
            
            -
            
            
            25,267Total
                interest income
            
            
            989,629
            
            
            1,496,298
            
            
            3,256,154
            
            
            4,568,795**Interest
                Expense**Interest
                and fees on notes
            
            
            690,752
            
            
            991,827
            
            
            2,314,668
            
            
            2,945,585Interest
                on other loans
            
            
            27,312
            
            
            124,500
            
            
            133,687
            
            
            325,000Interest
                on participation loans
            
            
            117,929
            
            
            -
            
            
            229,590
            
            
            -Total
                interest expense
            
            
            835,993
            
            
            1,116,327
            
            
            2,677,945
            
            
            3,270,585Net
                interest income
            
            
            153,636
            
            
            379,971
            
            
            578,209
            
            
            1,298,210**Provision
                for Loan Losses**
            
            
            118,286
            
            
            75,000
            
            
            272,384
            
            
            195,000**Net
                Interest Income after Provision for Loan Losses**
            
            
            35,350
            
            
            304,971
            
            
            305,825
            
            
            1,103,210**Non-interest
                Income**Rental
                income
            
            
            40,995
            
            
            16,536
            
            
            90,038
            
            
            46,057Loss
                on sale of real estate owned
            
            
            -
            
            
            (8,864
            )
            
            (4,732
            )
            
            (20,736
            )Loss
                on sale of securities
            
            
            -
            
            
            (52,567
            )
            
            -
            
            
            (52,567
            )Other
            
            
            637
            
            
            2,742
            
            
            9,212
            
            
            8,446Total
                non-interest income
            
            
            41,632
            
            
            (42,153
            )
            
            94,518
            
            
            (18,800
            )**Non-interest
                Expense**Salaries
                and wages
            
            
            75,672
            
            
            127,827
            
            
            244,108
            
            
            374,179Professional
                fees
            
            
            19,612
            
            
            71,726
            
            
            124,144
            
            
            136,106Offering
                costs
            
            
            32,235
            
            
            40,663
            
            
            104,438
            
            
            124,065Administration
            
            
            11,414
            
            
            12,001
            
            
            61,088
            
            
            43,021Real
                estate maintenance
            
            
            32,211
            
            
            19,238
            
            
            87,589
            
            
            77,286Insurance
            
            
            17,219
            
            
            22,947
            
            
            55,850
            
            
            51,577Depreciation
            
            
            16,824
            
            
            14,746
            
            
            47,163
            
            
            43,573Rent
            
            
            28,591
            
            
            28,428
            
            
            86,506
            
            
            86,401Bank
                charges
            
            
            14,334
            
            
            13,788
            
            
            41,127
            
            
            34,411Stock
                based compensation-employees
            
            
            2,780
            
            
            4,000
            
            
            10,573
            
            
            15,500Other
            
            
            8,031
            
            
            2,047
            
            
            12,601
            
            
            15,754Total
                non-interest expense
            
            
            258,923
            
            
            357,411
            
            
            875,187
            
            
            1,001,873**Net
                (Loss) Income**
            
            $
            (181,941
            )
            $
            (94,593
            )
            $
            (474,844
            )
            $
            82,537Basic
                earnings per share
            
            $
            (0.07
            )
            $
            (0.03
            )
            $
            (0.18
            )
            $
            0.03Diluted
                earnings per share
            
            $
            (0.07
            )
            $
            (0.03
            )
            $
            (0.18
            )
            $
            0.03Cash
                dividends paid per common share
            
            $
            -
            
            $
            0.02
            
            $
            -
            
            $
            0.06





*The
      accompanying notes are an integral part of these
      statements.*


-4-





**KH
      FUNDING COMPANY**


**STATEMENT
      OF CHANGES IN STOCKHOLDERS’ EQUITY (UNAUDITED)**


**FOR
      THE NINE MONTHS ENDED SEPTEMBER 30, 2008 and 2007**





**Common Stock**
            
            **Paid-In**
            
            **Accumulated**
            
            **Subscription**
              **Note**
            
            **Accumulated**
              **Other**
              **Comprehensive**
            
            **Total**
              **Stockholders’****Shares**
            
            **Amount**
            
            **Capital**
            
            **Deficit**
            
            **Receivable**
            
            **(Loss) Income**
            
            **Equity****Balances
                at January 1, 2007**
            
            
            2,726,951
            
            $
            27,269
            
            $
            1,879,783
            
            $
            (269,120
            )
            $
            (185,450
            )
            $
            (34,168
            )
            $
            1,418,314**Additional
                stock issued**
            
            
            330
            
            
            4
            
            
            856
            
            
            –
            
            
            –
            
            
            –
            
            
            860**Stock
                Redemptions**
            
            
            (2,300
            )
            
            (23
            )
            
            (4,577
            )
            
            
            
            
            
            
            
            
            
            
            (4,600
            )**Dividends
                (paid $0.06 per share)**
            
            
            
            
            
            
            
            
            (164,028
            )
            
            
            
            
            
            
            
            
            
            
            (164,028
            )**Stock
                Based Compensation Expense**
            
            
            
            
            
            
            
            
            15,500
            
            
            –
            
            
            –
            
            
            –
            
            
            15,500**Comprehensive
                income**Net
                income for period ended September 30, 2007
            
            
            –
            
            
            –
            
            
            –
            
            
            82,537
            
            
            –
            
            
            –
            
            
            82,537Change
                in fair value of investments
            
            
            –
            
            
            –
            
            
            –
            
            
            –
            
            
            –
            
            
            34,168
            
            
            34,168**Total
                Comprehensive Income for the Period**
            
            
            –
            
            
            –
            
            
            –
            
            
            –
            
            
            –
            
            
            –
            
            
            116,705**Balances
                at September 30, 2007**
            
            
            2,724,981
            
            $
            27,250
            
            $
            1,727,534
            
            $
            (186,583
            )
            $
            (185,450
            )
            $
            –
            
            $
            1,382,751**Balances
                at January 1, 2008**
            
            
            2,724,981
            
            $
            27,250
            
            $
            1,730,911
            
            $
            (533,645
            )
            $
            (185,450
            )
            $
            0
            
            $
            1,039,066**Stock
                Redemption**
            
            
            (150,000
            )
            
            (1,500
            )
            
            (298,500
            )
            
            –
            
            
            –
            
            
            –
            
            
            (300,000
            )**Stock
                Based Compensation Expense**
            
            
            
            
            
            
            
            
            10,573
            
            
            
            
            
            
            
            
            
            
            
            10,573**Net
                loss for period ended September 30, 2008**
            
            
            –
            
            
            –
            
            
            –
            
            
            (474,844
            )
            
            –
            
            
            –
            
            
            (474,844
            )**Balances
                at September 30, 2008**
            
            
            2,574,981
            
            $
            25,750
            
            $
            1,442,984
            
            $
            (1,008,489
            )
            $
            (185,450
            )
            $
            0
            
            $
            274,795





*The
      accompanying notes are an integral part of these
      statements.*


-5-


**KH
      FUNDING COMPANY**


**STATEMENTS
      OF CASH FLOWS (UNAUDITED)**





**For the nine months ended September 30,****2008**
            
            **2007****Cash
                from Operating Activities**Net
                (loss) income
            
            $
            (474,844
            )
            $
            82,537**Adjustments
                to Reconcile Net Income to Net Cash from Operating
                Activities:**Depreciation
            
            
            47,165
            
            
            43,573Amortization
                of loan fees
            
            
            (22,108
            )
            
            (87,000
            )Provision
                for loan losses
            
            
            272,384
            
            
            195,000Write-down
                of real estate held for sale
            
            
            37,954
            
            
            -Loss
                on sale of real estate owned
            
            
            4,732
            
            
            20,736Stock
                based compensation expense
            
            
            10,573
            
            
            15,500**Changes
                in Operating Assets and Liabilities**Accrued
                late charges
            
            
            (27,235
            )
            
            (7,406
            )Prepaid
                expenses
            
            
            30,008
            
            
            (113,293
            )Decrease
                (increase) in Interest receivable
            
            
            662,496
            
            
            (386,374
            )Increase
                in Interest payable (included in notes payable)
            
            
            1,369,899
            
            
            1,644,812Accounts
                payable and accrued expenses
            
            
            4,198
            
            
            10,894Prepaid
                offering costs
            
            
            (9,408
            )
            
            167,724Deferred
                loan origination costs
            
            
            9,900
            
            
            7,680Unamortized
                brokerage fees
            
            
            50,000
            
            
            13,470Long
                term lease liability
            
            
            7,886
            
            
            -Prepaid
                loan expenses
            
            
            76,797
            
            
            51,941**Net
                Cash Provided by Operating Activities**
            
            
            2,050,397
            
            
            1,712,361**Cash
                Flows from Investing Activities**Principal
                repayments from borrowers
            
            
            10,695,201
            
            
            13,489,339Loans
                made to borrowers
            
            
            (6,093,811
            )
            
            (10,999,358
            )Proceeds
                from marketable securities and other investments
            
            
            -
            
            
            562,750Net
                other receivables
            
            
            (136,186
            )
            
            (164,086
            )Purchase
                of fixed assets
            
            
            -
            
            
            (41,887
            )Proceeds
                from sale of real estate owned
            
            
            16,151
            
            
            478,473Payments
                on other real estate owned
            
            
            (14,285
            )
            
            (4,600
            )**Net
                Cash Provided by Investing Activities**
            
            
            4,467,070
            
            
            3,320,631**Cash
                Flows from Financing Activities**Proceeds
                from investor notes
            
            
            1,397,180
            
            
            2,248,012Principal
                payments on investor notes
            
            
            (13,352,867
            )
            
            (17,407,737
            )Increase
                in participation loans
            
            
            4,804,058
            
            
            -Increase
                in borrowings
            
            
            848,793
            
            
            6,684,548Payment
                of dividends
            
            
            -
            
            
            (164,028
            )Proceeds
                from sale of common stock
            
            
            -
            
            
            860Redemption
                of common stock
            
            
            (300,000
            )
            
            (4,600
            )Decrease
                in escrow and security deposits
            
            
            2,113
            
            
            (47,337
            )**Net
                Cash Used in Financing Activities**
            
            
            (6,600,723
            )
            
            (8,690,282
            )**Net
                Decrease in Cash**
            
            
            (83,256
            )
            
            (3,657,290
            )**Cash
                Balance,**beginning of period
            
            
            95,622
            
            
            3,823,013**Cash
                Balance,**end
                of period
            
            $
            12,366
            
            $
            165,723**Supplemental
                Cash Flow Information:**Interest
                paid
            
            $
            1,308,046
            
            $
            1,625,773Transfer
                of loans to real estate owned
            
            $
            1,031,280
            
            $
            1,856,922





*The
      accompanying notes are an integral part of these
      statements.*


-6-


KH
      Funding Company


Notes
      to
      Interim Financial Statements


For
      the
      Nine Months Ended September, 2008 and 2007


(Unaudited)





**NOTE
      A—BASIS OF PRESENTATION**





The
      financial statements of KH Funding Company (the “Company”) conform to accounting
      principles generally accepted in the United States of America (“GAAP”) and to
      prevailing practices within the Company’s industry. The accompanying interim
      financial statements are unaudited; however, in the opinion of management all
      adjustments necessary to present fairly the financial position at September
      30,
      2008, the results of operations for the three- and nine-month periods ended
      September 30, 2008 and 2007, changes in stockholders’ equity for the nine-month
      periods ended September 30, 2008 and 2007, and cash flows for the nine-month
      periods ended September 30, 2008 and 2007, have been included. All such
      adjustments are of a normal recurring nature. The amounts as of December 31,
      2007 were derived from audited financial statements. The results of operations
      for the three- and nine-month period ended September 30, 2008 are not
      necessarily indicative of the results to be expected for any other interim
      period or for the full year. This Quarterly Report on Form 10-Q should be read
      in conjunction with the Company’s Annual Report on Form 10-KSB for the year
      ended December 31, 2007.





The
      financial statements contemplate continuation of the Company as a going concern.
      As discussed in Note B to the audited financial statements presented in the
      Company’s Annual Report on Form 10-KSB for the year ended December 31, 2007, the
      Company experienced significant delays starting in the second quarter of 2006
      in
      obtaining an effective registration statement covering the offer and sale of
      its
      investor notes. The Company’s most recent registration statement, covering the
      offer and sale of an aggregate of $250 million of our Series 3 Secured Notes
      and
      Series 4 Unsecured Notes, was declared effective by the Securities and Exchange
      Commission and by the Maryland Division of Securities on November 10, 2008.
      The
      Company filed this registration statement with securities regulators in several
      other states and expects that the registration in those states will be declared
      effective shortly. During this delay, the Company was unable to raise
      significant funds for operations and, as a result, there is a significant risk
      that the Company may have difficulty meeting its future liquidity needs. The
      Company requires cash to make and acquire loans, redeem outstanding investor
      notes, and pay other operational expenses. Although the Company anticipates
      that
      it will raise money through this offering and that the Company will continue
      to
      receive unscheduled and scheduled loan payments on a going-forward basis, there
      can be no assurance that funds generated from this offering or from loan payoffs
      and scheduled payments in the future will exceed the amounts needed to fund
      redemption requests and pay other operational expenses. Additionally,
      stockholders’ equity at September 30, 2008 has decreased to 0.58% of total
      assets, which the Company believes to be inadequate to fully protect it against
      potential losses. Accordingly, because both future income from loans and cash
      needed for operations, including investor note redemptions, are uncertain and
      because the Company cannot predict whether its offering will be successful,
      there is substantial doubt about the Company’s ability to continue as a going
      concern.





**NOTE
      B—SIGNIFICANT ACCOUNTING POLICIES AND RECENT ACCOUNTING
      PRONOUNCEMENTS**





**Significant
      Accounting Policies and Estimates**





Note
      A to
      the audited financial statements contained in the Company’s Annual Report on
      Form 10-KSB for the year ended December 31, 2007 describes the significant
      accounting policies used in the preparation of the Company’s financial
      statements.





**Nature
      of Operations**





The
      Company conducts operations from its headquarters in Silver Spring, Maryland.
      Its primary business activities consist of originating, acquiring and servicing
      mortgage loans, and issuing interest-bearing debt securities to investors.
      The
      Company purchases residential first and second mortgage loans from other lenders
      and banks primarily in the Baltimore, MD and Washington DC metropolitan areas.
      The Company also directly originates small commercial real estate mortgage
      loans
      and investment property residential mortgage loans.





**Use
      of Estimates in Preparing Financial Statements**





In
      preparing financial statements in conformity with GAAP, management is required
      to make estimates and assumptions that affect the reported amounts of assets
      and
      liabilities and the disclosure of contingent assets and liabilities at the
      date
      of the financial statements and revenue and expenses during the reporting
      period. Actual results could differ materially from those
      estimates.


-7-





**Earnings
      Per Share**





Basic
      earnings per share is derived by dividing net income available to common
      stockholders by the weighted-average number of common shares outstanding and
      does not include the effect of any potentially dilutive common stock
      equivalents. Diluted earnings per share is derived by dividing net income by
      the
      weighted-average number of shares outstanding, adjusted for the dilutive effect
      of outstanding stock options. As of September 30, 2008 and September 30, 2007,
      the Company had outstanding stock options to purchase 241,250 and 341,250 shares
      of common stock, respectively. For the nine months ended September 30, 2008
      and
      2007, options to purchase 80,000, and 150,000 shares, respectively, were
      excluded from the computation of dilutive earnings per share as their effect
      would have been anti-dilutive.





**For The Three**
              **Months Ended**
              **September 30,**
            
            **For The Nine**
              **Months Ended**
              **September 30,****2008**
            
            **2007**
            
            **2008**
            
            **2007****(unaudited)**
            
            **(unaudited)**Basic:Net
                income (attributable to common stock)
            
            $
            (181,941
            )
            
            (94,593
            )
            $
            (474,844
            )
            $
            82,537Weighted
                average common shares outstanding
            
            
            2,574,981
            
            
            2,725,331
            
            
            2,574,981
            
            
            2,726,485Basic
                earnings per share
            
            $
            (0.07
            )
            $
            (0.03
            )
            $
            (0.18
            )
            $
            0.03Diluted:Net
                income (attributable to common stock)
            
            $
            (181,941
            )
            $
            (94,593
            )
            $
            (474,844
            )
            $
            82,537Weighted
                average common shares outstanding
            
            
            2,574,981
            
            
            2,725,331
            
            
            2,574,981
            
            
            2,726,485Dilutive
                effect of stock options
            
            
            -
            
            
            80,298
            
            
            -
            
            
            91,250Weighted
                average common shares outstanding-diluted
            
            
            2,574,981
            
            
            2,805,629
            
            
            2,574,981
            
            
            2,817,735Diluted
                earnings per share
            
            $
            (0.07
            )
            
            (0.03
            )
            $
            (0.18
            )
            $
            0.03





**Income
      Taxes**





The
      Company has elected under Subchapter S of the Internal Revenue Code to be
      treated as an “S Corporation” for tax purposes. Accordingly, items of income and
      loss are taxed to the Company’s stockholders and no provision for income taxes
      is necessary in the financial statements.





**New
      Accounting Pronouncements**





In
      September 2006, the Financial Accounting Standards Board (“FASB”) issued
      Statement of Financial Accounting Standards (“SFAS”) No. 157, *“Fair
      Value Measurements* ”
(“SFAS
      157”). This statement provides a single definition of fair value, a framework
      for measuring fair value, and expanded disclosures concerning fair value.
      Previously, different definitions of fair value were contained in various
      accounting pronouncements creating inconsistencies in measurement and
      disclosures. SFAS 157 applies under those previously issued pronouncements
      that
      prescribe fair value as the relevant measure of value, except SFAS No. 123(R)
      and related interpretations and pronouncements that require or permit
      measurement similar to fair value but are not intended to measure fair value.
      This pronouncement is effective for fiscal years beginning after November 15,
      2007. The adoption of this standard did not have a material impact on the
      Company’s financial statements.





In
      February 2007, the FASB issued SFAS No. 159, *The
      Fair Value Option for Financial Assets and Financial Liabilities - Including
      an
      amendment of FASB Statement No. 115* ,
      which
      generally permits the measurement of selected eligible financial instruments,
      including investment securities, at fair value as of specified election dates
      and the reporting of unrealized gains or losses on those instruments in earnings
      at each subsequent reporting date. Generally, the fair value option may be
      applied on an instrument by instrument basis, but once applied, the election
      is
      irrevocable and is applied to the entire instrument. The statement is effective
      for fiscal years beginning after November 15, 2007, with early adoption
      permitted as of the beginning of the fiscal year that begins on or before
      November 15, 2007. The adoption of this standard did not have a material impact
      on the Company’s financial statements.


-8-





In
      December 2007, the FASB issued SFAS 141(R), “ *Business
      Combinations (Revised 2007)* (“SFAS
      141R”). SFAS 141R replaces SFAS 141, *“Business
      Combinations* ”,
      and
      applies to all transactions and other events in which one entity obtains control
      over one or more other businesses. SFAS 141R requires an acquirer, upon
      initially obtaining control of another entity, to recognize assets, liabilities
      and any non-controlling interest in the acquiree at fair value as of the
      acquisition date. Contingent consideration is required to be recognized and
      measured at fair value on the date of acquisition rather than at a later date
      when the amount of that consideration may be determinable beyond a reasonable
      doubt. This fair value approach replaces the cost-allocation process required
      under SFAS 141 whereby the cost of an acquisition was allocated to the
      individual assets acquired and liabilities assumed based on their estimated
      fair
      value. SFAS 141R requires acquirers to expense acquisition-related costs as
      incurred rather than allocating such costs to the assets acquired and
      liabilities assumed, as was previously the case under SFAS 141. Under SFAS
      141R,
      the requirement of SFAS 146, *“Accounting
      for Costs Associated with Exit of Disposal Activities”* ,
      would
      have to be met in order to accrue for a restructuring plan in purchase
      accounting. Pre-acquisition contingencies are to be recognized at fair value,
      unless it is a non-contractual contingency that is not likely to materialize,
      in
      which case nothing should be recognized in purchase accounting and, instead,
      that contingency would be subject to the probable and estimable recognition
      criteria of SFAS 5, “ *Accounting
      for Contingencies* ”.
      SFAS
      141R is expected to have a significant impact on the Company’s accounting for
      business combinations closing on or after January 1, 2009.





In
      December 2007, the FASB issued SFAS No. 160, “ *Noncontrolling
      Interest in Consolidated Financial Statements, an amendment of ARB Statement
      No.
      51* ”
(“SFAS
      160”). SFAS 160 amends Accounting Research Bulletin (ARB) No. 51, “ *Consolidated
      Financial Statements* ”,
      to
      establish accounting and reporting standards for the non-controlling interest
      in
      a subsidiary and for the deconsolidation of a subsidiary. SFAS 160 clarifies
      that a non-controlling interest in a subsidiary, which is sometimes referred
      to
      as a minority interest, is an ownership interest in the consolidated entity
      that
      should be reported as a component of equity in the consolidated financial
      statements. Among other requirements, SFAS 160 requires consolidated net income
      to be reported at amounts that include amounts attributable to both the parent
      and the non-controlling interest. It also requires disclosure, on the face
      of
      the consolidated income statement, of the amount of consolidated net income
      attributable to the parent and to the non-controlling interest. SFAS 160 is
      effective for the Company on January 1, 2009 and is not expected to have a
      significant impact on the Company’s financial statements.





In
      March
      2008, the FASB issued SFAS No. 161, “ *Disclosures
      about Derivative Instruments and Hedging Activities, an amendment of FASB
      Statement No. 133* ”
(“SFAS
      161”). SFAS 161 is intended to enhance the current disclosure framework
      previously required for derivative instruments and hedging activities under
      SFAS
      No. 133, “ *Accounting
      for Derivative Instruments and Hedging Activities* ”,
      to
      include how and why an entity uses derivative instruments, how derivative
      instruments and related hedge items are accounted for and their impact on an
      entity’s financial position, results of operations, and cash flows. This
      standard is effective for fiscal years and interim periods beginning after
      November 15, 2008, with early adoption encouraged. Although the Company does
      not
      currently utilize derivative instruments, it is currently evaluating the impact
      of this new standard on its financial position, results of operations and cash
      flows.





**NOTE
      C— LOANS RECEIVABLE, IMPAIRED LOANS AND ALLOWANCE FOR LOAN LOSSES**




**Loans
      Receivable**





Loans
      receivable are stated as unpaid principal balance net of any deferred fees
      and
      payments in process, less the allowance for loan losses.





Interest
      income from loans receivable is recognized using the interest method whereby
      interest income is recognized using the loan’s effective rate based upon
      outstanding principal. Loan origination fees received from borrowers are
      deferred and amortized into income over the established average life of related
      loans under a method which approximates the effective interest rate method.
      Loan
      premiums and discounts are also amortized into interest income under the same
      method.





The
      Company pays fees to third parties in connection with the acquisition of loans.
      These costs are amortized against interest income over the estimated average
      life of the loans under a method which approximates the effective interest
      rate
      method.





The
      Company incurs direct loan origination costs in its direct lending activities.
      These costs are capitalized and amortized against interest income over the
      estimated average life of the loans under a method which approximates the
      effective interest rate method.


-9-


**Impaired
      Loans**





Under
      the
      provisions of SFAS Nos. 114 and 118, *Accounting
      by Creditors for Impairment of a Loan* ,
      a loan
      is considered impaired (or nonaccrual) if it is probable that the Company will
      not collect all principal and interest payments according to the loan’s
      contracted terms. The impairment of the loan is measured at the present value
      of
      the expected cash flows using the loan’s effective interest rate, or the loan’s
      observable market price. Interest income generally is not recognized on specific
      impaired loans unless the likelihood of further loss is remote. Interest
      payments received on such loans are applied as a reduction of the loan’s
      principal balance. Interest income on the other nonaccrual loans is recognized
      only to the extent of interest payments received





Information
      with respect to impaired loans and the related allowance for loan losses is
      shown below:





**September 30,**
              **2008**
            
            **December 31,**
              **2007****(unaudited)**Total
                recorded investment in impaired loans
            
            $
            3,582,918
            
            $
            510,697Amount
                of that recorded investment for which there is a related allowance
                for
                loan losses
            
            $
            2,317,436
            
            $
            510,697Amount
                of related allowance for loan losses associated with such
                investment
            
            $
            500,124
            
            $
            306,815Amount
                of that recorded investment for which there is no related allowance
                for
                loan losses
            
            $
            1,265,482
            
            $
            -





**For the nine months**
              **ended September 30,**
              **2008**
            
            **For the year ended**
              **December 31,**
              **2007****(unaudited)**Average
                recorded investment in impaired loans during period
            
            $
            2,046,807
            
            $
            581,296Related
                amount of interest income recognized within period when loans were
                impaired
            
            $
            -
            
            $
            -Amount
                of income recognized using cash basis during time within period that
                loan
                was impaired
            
            $
            -
            
            $
            -





At
      September 30, 2008 and December 31, 2007, the Company had loans of $5,209,980
      and $5,002,259, respectively, which were more than 90 days past due and for
      which the Company continues to accrue interest. The Company believes that these
      loans are adequately secured and that both the principal and the related accrued
      interest are collectible.





Analysis
      of the allowance for loan losses is as follows:





**For the nine months**
              **ended September 30,**
              **2008**
            
            **For the nine months**
              **ended September 30,**
              **2007****(unaudited)**
            
            **(unaudited)**Beginning
                balance
            
            $
            495,480
            
            $
            452,154Provision
                for loan losses
            
            
            272,384
            
            
            195,000Loans
                charged off
            
            
            (107,440
            )
            
            (232,800
            )Ending
                Balance
            
            $
            660,424
            
            $
            414,354





**NOTE
      D—INVESTMENTS**





Other
      investments available for sale of $25,437 at September 30, 2008 and December
      31,
      2007 consist of an equity investment in a private company. The cost of this
      non-marketable security approximates the fair value of this
      investment.





**NOTE
      E—RELATED PARTY TRANSACTIONS**





Included
      in notes receivable at September 30, 2008 and December 31, 2007, are 12 notes
      totaling $10,735,665 and 12 notes totaling $10,649,192, respectively, from
      officers, stockholders and entities controlled by a stockholder. These notes
      all
      have annual maturities and are due in full on the maturity date unless extended
      by the Company. The interest rates on these notes range between 5.99% and 12.5%.
      The majority (94.5%) of these notes receivable were due from one stockholder
      and
      its related interests, who owed $10,145,405 as of September 30,
      2008.


-10-





Included
      in the notes payable and other loans payable balances at September 30, 2008
      and
      December 31, 2007, are 59 notes totaling $6,704,551 and 66 notes totaling
      $11,437,449, respectively, which are held by officers and stockholders. These
      notes were issued at the rates in effect for the applicable terms selected
      as of
      the date the notes were issued.





During
      the nine months ended September 30, 2008, the Company had short-term net
      borrowings of $848,793 from fifteen stockholders and holders of investment
      notes. These borrowings are included with Other Loans Payable on the balance
      sheet. These loans are due and payable upon demand.





There
      is
      a note receivable of $185,450 included in other receivables, shown on the
      balance sheet at September 30, 2008 and December 31, 2007 as contra-equity,
      made
      to the Company’s CEO for the purchase of 100,000 shares of stock in the Company,
      which secures the loan. This loan is an interest-only loan, payable on demand,
      and the interest
      rate is seven percent. At September 30, 2008 and December 31, 2007, all payments
      under this loan had been timely made and there was no accrued interest
      receivable on this loan.





Included
      in the notes receivable at September 30, 2008 are six loans in the amount of
      $10,145,405 to a trust for the benefit of a significant stockholder. The
      majority of these loans ($9.75 million) were made prior to the period ending
      December 31, 2007. The proceeds of these loans were used to purchase real estate
      which serves as security for the loans. The Company holds a first or second
      lien
      position with respect to the collateral securing approximately $9.75 million
      of
      these loans as well as other real and personal collateral. The loans bear
      interest at 8% per annum and have some variable up-side features. Additional
      interest is earned on certain loans if the rental income the borrower receives
      from the property exceeds certain allowable expenses. In addition, upon the
      sale
      of certain real property(ies) (or components thereof), the Company is to receive
      one quarter or one-half, depending on the specific property, of any gain after
      adjusting for certain costs and commissions. The loans do not have any variable
      down-side features which would cause interest to be lower than the stated rate
      on each loan. Under the terms of the loans any refinancing or sale of the
      properties must be approved by the Company in advance. During the quarters
      ended
      September 30, 2008 and 2007, the Company recognized $0 in additional interest
      from the above loan features. The Company recognizes such additional interest
      earned through variable up-side loan features only when the additional interest
      is collected.





Management
      believes that all of the above transactions were consummated on substantially
      the same terms, including interest rates and collateral, as those prevailing
      for
      comparable transactions with other customers.





During
      the nine months ended September 30, 2008, the Company purchased 150,000 shares
      of its common stock held by Robert L. Harris, Chief Executive Officer and
      President, at $2.00 per share, for a total of $300,000.





**NOTE
      F—STOCK BASED COMPENSATION**





The
      Company has granted stock-based compensation awards to employees and directors.
      Awards may consist of common stock or stock options. The Company’s stock options
      have five-year terms and vest over three years in three equal annual
      installments. The stock options provide for option exercise prices equal to
      or
      greater than the fair market value of the common stock at the date of the grant,
      as determined by the Board on the grant date.





No
      stock
      options were granted during the nine months ended September 30, 2008 or 2007.
      The Company accrues related compensation expenses as its options vest in
      accordance with SFAS 123(R), *Share-Based
      Payment.* The
      Company recognized $10,573 and $15,500 stock-based compensation expense during
      the nine months ended September 30, 2008 and 2007, respectively, from the
      vesting of stock options issued in earlier periods. Stock-based compensation
      includes the value of stock granted to directors for their service, which was
      $0
      and $0, respectively, for the nine months ended September 30, 2008 and
      2007.


-11-


A
      summary
      of stock option activity during the nine months ended September 30, 2008 and
      related information is included in the table below:





**Number of**
              **Options**
            
            **Weighted-**
              **Average Exercise**
              **Price**
            
            **Weighted-Average**
              **Remaining**
              **Contractual Life**
              **(in years)**
            
            **Aggregate**
              **Intrinsic**
              **Value**Outstanding
                at January 1, 2008
            
            
            241,250
            
            $
            2.39
            
            
            2.34Granted
            
            
            -Exercised
            
            
            -Forfeited
                or expired
            
            
            -Outstanding
                at September 30, 2008
            
            
            241,250
            
            
            2.39
            
            
            1.59
            
            $
            -Exercisable
                at September 30, 2008
            
            
            214,584
            
            
            2.30
            
            
            1.44
            
            
            -





**NOTE
      G—FAIR VALUE MEASUREMENTS**




SFAS
      No. 157, *Fair
      Value Measurement* ,
      defines
      fair value, establishes a framework for measuring fair value, establishes a
      three-level valuation hierarchy for disclosure of fair value measurement and
      enhances disclosure requirements for fair value measurements. The valuation
      hierarchy is based upon the transparency of inputs to the valuation of an asset
      or liability as of the measurement date. The three levels are defined in terms
      of those inputs as follow:





Level
                1
            Quoted
                prices (unadjusted) in active markets for identical assets or
                liabilities;Level
                2
            Significant
                inputs other than quoted prices included within Level 1 that are
                either
                directly or indirectly observable;Level
                3
            Significant
                unobservable inputs in which little or no market activity exists,
                therefore requiring an entity to develop its own assumptions about
                the
                assumptions that market participants would use in
                pricing.




Impaired
      Loans




The
      Company does not record loans at fair value on a recurring basis, however,
      from
      time to time, a loan is considered impaired and an allowance for loan loss
      is
      established. Loans for which it is probable that payment of interest and
      principle will not be made in accordance with the contractual terms of the
      loan
      are considered impaired. Once a loan is identified as individually impaired,
      management measures impairment in accordance with SFAS 114, “Accounting by
      Creditors for Impairment of a Loan,” (SFAS 114). The fair value of impaired
      loans is estimated using one of several methods, including the collateral value,
      market value of similar debt, enterprise value, liquidation value and discounted
      cash flows. Those impaired loans not requiring a specific allowance represents
      loans for which the fair value of expected repayments or collateral exceed
      the
      recorded investment in such loans. At September 30, 2008, substantially all
      of
      the totally impaired loans were evaluated based upon the fair value of the
      collateral. In accordance with SFAS 157, impaired loans where an allowance
      is
      established based on the fair value of collateral require classification in
      the
      fair value hierarchy. When the fair value of the collateral is based on an
      observable market price or a current appraised value, the Company records the
      loan as nonrecurring Level 2. When an appraised value is not available or
      management determines the fair value of the collateral is further impaired
      below
      the appraised value and there is no observable market price, the Company records
      the loan as nonrecurring Level 3.


-12-




Assets
      and Liabilities Measured at Fair Value on a Recurring Basis




The
      table
      below presents the recorded amount of assets and liabilities measured at fair
      values on a recurring basis as of September 30, 2008:





**Assets:**
            
            **Carrying**
              **Value**
              **(Fair Value)**
            
            **Quoted Prices**
              **(Level 1)**
            
            **Significant Other**
              **Observable Inputs**
              **(Level 2)**
            
            **Significant**
              **Unobservable**
              **Inputs (Level 3)**Investments
                Available for Sale
            
            $
            25,437
            
            $
            -
            
            $
            -
            
            $
            25,437




Assets
      and Liabilities Measured at Fair Value on a Nonrecurring Basis




We
      may be
      required from time to time, to measure certain assets at fair value on a
      nonrecurring basis in accordance with U.S. generally accepted accounting
      principles. These include assets that are measured at the lower of cost or
      market that were recognized at fair value below cost. Assets measured at fair
      value on a nonrecurring basis as of September 30, 2008 are
      included in the table below:





**Assets:**
            
            **Carrying**
              **Value**
              **(Fair Value)**
            
            **Quoted Prices**
              **(Level 1)**
            
            **Significant Other**
              **Observable Inputs**
              **(Level 2)**
            
            **Significant**
              **Unobservable**
              **Inputs (Level 3)**Impaired
                Loans
            
            $
            3,582,918
            
            $
            -
            
            $
            3,582,918
            
            $
            -Other
                Real Estate Owned - Held for sale
            
            $
            1,852,923
            
            $
            -
            
            $
            1,852,923
            
            $
            -





**NOTE
      H—COMMITMENTS AND CONTINGENT LIABILITIES**





**Off-Balance
      Sheet Arrangements**




The
      Company enters into off-balance sheet arrangements in the normal course of
      its
      business. These arrangements consist primarily of lines-of-credit and draw-type
      loans. At September 30, 2008, the Company had $4.48 million in loans of this
      type. The unused or unfunded amount on these types of loans totaled $.84 million
      as of September 30, 2008.





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





Portions
      of this report contain “forward-looking statements,” as that term is defined in
      the Private Securities Litigation Reform Act of 1995. Such forward-looking
      statements are based on management’s expectations, estimates, projections and
      assumptions. These statements may be identified by the use of forward-looking
      words or phrases such as “should”, “expects”, “anticipates”, “plans”,
“believes”, “estimates”, “might result”, “projects” and variations of such words
      and similar expressions. These statements are not guarantees of future
      performance and involve certain risks and uncertainties that are difficult
      to
      predict. Therefore, actual future results and trends may differ materially
      from
      what is indicated in forward-looking statements due to a variety of factors.
      Such risks and uncertainties include liquidity risks associated with our
      investor notes payable on demand by the holders, other loans and short-term
      borrowings, delinquencies in our loan portfolio, capital levels, changes in
      market interest rates, inability to generate new loans, and competitive factors
      in our marketplace. These risks and uncertainties are described in detail in
      the
      Company’s Annual Report on Form 10-KSB for the year ended December 31, 2007 and
      in the reports that the Company files with the Securities and Exchange
      Commission (the “SEC”) (see Item 1A of Part II of this report). Readers are
      cautioned not to place undue reliance on such forward looking statements, which
      speak only as of the date of this report. Except as required by law, the Company
      assumes no obligation to update any forward looking statements even if
      experience or future changes make it clear that projected results expressed
      or
      implied in such statements will not be realized.





The
      information contained in this report pertains to the registrant, KH Funding
      Company. References to the “Company,” “KH Funding” or “we,” “our” and “us” refer
      to KH Funding Company.





**Recent
      Developments**





Our
      ability to engage in business is dependent, in part, on our ability to raise
      funds through the sale of our investor notes. We have been unable to sell our
      investor notes since the second quarter of 2006 due to delays in obtaining
      an
      effective registration statement for our offerings. On
      November 10, 2008, the SEC and the Maryland Securities Division declared our
      most recent registration statement (covering up to $250 million in Series 3
      Senior Secured Notes and Series 4 Subordinated Unsecured Notes) effective,
      and
      we expect that our concurrent registrations in certain other states will be
      declared effective shortly. Accordingly, we may now re-commence our selling
      efforts.


-13-





On
      November 6, 2008, without admitting or denying the conclusions of law contained
      therein, we entered into a Consent Order with the Maryland Division of
      Securities which resolved various investigations into our securities operations
      that have been discussed in our previous reports. These investigations related
      to (i) the actions of a former Senior Vice President who allegedly
      misappropriated approximately $74,872 in
      checks
      from an investor between 2004 and 2006 which she tendered to this Senior Vice
      President for deposit into her investor account but which he instead deposited
      into his personal accounts, (ii) the fact that we used this
      former Senior Vice President to offer and sell our investor notes without him
      being registered as an issuer-agent as required by the Maryland Securities
      Act,
      and (iii) certain of our recordkeeping and other internal controls which the
      Maryland Securities Division believes were inadequate and may have contributed
      to an $864,000 loss allegedly suffered by a third party with whom this former
      Senior Vice President had outside relations. The Consent Order provides that
      our
      former Senior Vice President acted as an unregistered issuer-agent in violation
      of the Maryland Securities Act and that we used him as such in violation of
      the
      Maryland Securities Act. The Consent Order also provides that we violated the
      Maryland Securities Act by failing to disclose that we had outstanding
      redemption requests that were more than 30 days past due in two of the
      post-effective amendments to our registration statement that we filed with
      the
      Maryland Securities Division for review and comment. Under the Consent Order,
      we
      agreed to pay a civil penalty of $100,000, of which $85,000 was waived due
      to
      our financial condition. The Consent Order also requires us to disclose in
      the
      documents we file with the SEC our record keeping and other internal control
      deficiencies, to keep the Maryland Securities Division abreast of the status
      of
      our investor note redemption payments, and to retain an independent consultant
      to help us identify problems with and strengthen our record keeping practices
      and our other internal controls and to help us ensure compliance with the
      Indenture to which our investor notes relate. Our obligations under the Consent
      Order will impose additional regulatory burdens on us, will require us to incur
      additional consulting expenses, and may cause us to discover other weaknesses
      or
      irregularities.





Also
      on
      November 6, 2008, we received a copy of a complaint that was filed against
      us by
      Samar Ghadry in the Montgomery County, Maryland Circuit Court pursuant to which
      she seeks compensatory damages in the amount of approximately $864,000 and
      punitive damages in the amount of $5.0 million. We have not been served with
      legal process. This litigation could
      subject us to substantial legal expenses, and we cannot predict the outcome
      of
      this litigation or its potential impact on us. This litigation is
      discussed further in Item 1 of Part II of this report.





**Recent
      Government Actions**





The
      following is a summary of recently enacted laws and regulations that could
      materially impact our results of operations or financial condition. This
      discussion is qualified in its entirety by reference to such laws and
      regulations.





On
      October 3, 2008, President Bush signed into law the Emergency Economic
      Stabilization Act of 2008 ( “EESA”) enacted by the U.S. Congress in response to
      the financial crises affecting the banking system and financial markets and
      going concern threats to investment banks and other financial institutions.
      Pursuant to EESA, the U.S. Department of Treasury (“U.S. Treasury”) has the
      authority to, among other things, purchase up to $700 billion of mortgages,
      mortgage-backed securities, and certain other financial instruments from
      financial institutions for the purpose of stabilizing and providing liquidity
      to
      the U.S. financial markets.





On
      October 14, 2008, the U.S Treasury announced the Capital Purchase Program
      (the “CPP”). The CPP makes $250 billion of capital available to U.S.
      financial institutions from the $700 billion authorized by the EESA in the
      form
      of preferred stock investments by the U.S. Treasury





Also
      on
      October 14, 2008, the Federal Deposit Insurance Corporation announced a new
      program - the Temporary Liquidity Guarantee Program (“TLGP”) - that provides
      unlimited deposit insurance on funds in non-interest-bearing transaction deposit
      accounts not otherwise covered by the existing deposit insurance limit of
      $250,000, as well as a 100% guarantee of the newly issued senior debt of all
      FDIC-insured institutions and their holding companies. All eligible institutions
      will be covered under the program for the first 30 days without incurring any
      costs.




The
      EESA,
      CPP and TLGP were intended to stabilize the financial industry, restore
      confidence in the industry, and ease liquidity concerns so that, among other
      things, financial institutions will increase their lending efforts, both with
      respect to consumers and other businesses. Because our primary business activity
      is making and purchasing loans, we believe that the success of these initiatives
      will have an impact on us, although there can be no assurance as to if, when
      or
      the extent to which we will see market improvements or any impact on our
      business and operations.


-14-


**Overview**





We
      conduct mortgage banking operations from our headquarters in Silver Spring,
      Maryland. Our primary business activities consist of originating, acquiring
      and
      servicing mortgage and business loans. We emphasize the direct origination
      of
      small commercial real estate mortgage loans and investment property residential
      mortgage loans. We also purchase first and second mortgage loans secured by
      residential real estate from other lenders and banks around the country. Over
      the past few years, our lending activities have focused primarily on purchasing,
      rather than originating, loans. This strategy is aimed at enabling us to expand
      our operations with limited amount of additional personal and expense because
      we
      anticipate that only a minimal expansion or our administrative functions will
      be
      needed to support an increased wholesale component in our operations. We plan
      to
      identify and utilize additional brokers, lenders and banks as sources for our
      loan acquisitions.





Prior
      to
      2007, our business activities consisted of purchasing mortgage loans (80% of
      our
      business) and of originating, acquiring and servicing mortgage loans (20% of
      our
      business). Since 2007, our business activities have been limited to funding
      existing lines of credit and draw-down loans and otherwise servicing our
      existing loan portfolio. To fund our operations and to satisfy our obligations
      under our outstanding investor notes, including redemption requests, we have
      traditionally relied on (i) funds received from loan pay-offs, (ii) interest
      and
      other fee income received on our loans, and (iii) funds raised through the
      issuance of interest-bearing debt securities to investors. However, we have
      not
      had the ability to publicly issue securities since the second quarter of 2006,
      so our operations have recently been funded solely through loan pay-offs,
      interest and other income received on our loans, and unsecured short-term
      borrowings. Once we are able to raise funds through the sale of our investor
      notes, we intend to again focus on purchasing, making and acquiring new mortgage
      loans.





Our
      net
      income depends largely upon our net interest income, which is the difference
      between interest income we earn from our loans and investments, referred to
      as
      interest-earning assets, and interest expense that we pay on investor notes
      and
      other borrowed funds, referred to as interest-bearing liabilities. Our net
      interest income may be affected by general economic conditions, policies
      established by regulatory authorities and competition.





In
      prior
      periods, we used funds obtained from loan repayments and offerings of our
      investor notes to originate most of the loans in our portfolio. However, rather
      than directly originating new loans, in the last six years we have increasingly
      engaged in the wholesale purchase of loans for our loan portfolio and are now
      purchasing approximately 80% of our new loans. We intend to continue to expand
      this wholesale component of our operations and expect it to continue to be
      a
      major part of our loan acquisition strategy. This strategy is aimed at enabling
      us to expand our operations with a limited amount of additional personnel and
      expense because we anticipate that only a minimal expansion of our
      administrative functions will be needed to support an increased wholesale
      component in our operations. We plan to identify and utilize additional brokers,
      lenders and banks as sources for our loan acquisitions.




Our
      business strategy is to grow and enhance our profitability by increasing our
      portfolio of mortgage and business loans. We anticipate that the funds necessary
      to carry through with this strategy will come from our lending activities and
      proceeds of sales of our investor notes. In addition, we may seek to raise
      funds
      through private sales of our capital stock.





Starting
      in the fourth quarter of 2004, we expanded the distribution for our investor
      notes by engaging in strategic alliances with several major financial services
      firms throughout the country. We currently have signed selling agreements with
      three NASD registered broker-dealers with a network of over 1,200 registered
      representatives in the Midwest and West. These alliances have given us the
      ability to sell our investor notes through a network of financial intermediaries
      in defined geographic locations. Through the middle of 2006, our distribution
      plan has been very successful, establishing close to 700 new investment accounts
      providing us with over $25,000,000 in funds. In 2006, sales by these
      broker-dealers established approximately 522 new investment accounts and
      provided over $11 million in funds. We plan to further increase our distribution
      network, and are currently in negotiations with other NASD member broker-dealers
      interested in distributing our investor notes in parts of the United States
      where we are not currently represented.





As
      reported elsewhere in this report, our business strategy was significantly
      hampered starting in the second quarter of 2006 because of our inability to
      raise funds through the sale of our investor notes in or from Maryland, our
      largest market, because of delays in registering our offering of such notes.
      Although our registration statement with respect to the offer and sale of up
      to
      $250 million in investor notes has been declared effective and we may now
      re-commence our offering efforts, there can be no assurance that our offering
      will be successful or, even if it is, that the proceeds we raise from our
      offering will allow us to fully implement our business
      strategy.


-15-


Recently,
      the sub-prime mortgage lending environment has experienced considerable strain
      from rising delinquencies and liquidity pressures. Several high profile
      sub-prime mortgage lenders have failed, and these failures have adversely
      impacted the financial markets and economy in general. These market conditions
      have resulted in increased scrutiny of sub-prime lending practices. Although
      we
      make and acquire loans that may be considered “sub-prime loans”, we believe that
      our exposure to problems in the industry is limited as a result of several
      factors. First, at September 30, 2008 our sub-prime loans amounted to only
      $3.52
      million, or 8.28% of our total loans. Second, we believe that we underwrite
      our
      sub-prime loans to a higher standard than that employed by some of the more
      aggressive lenders. Third, we do not offer or purchase the types of sub-prime
      loans that are receiving the harshest criticism from regulators, commentators
      and Congress. Notably, as a general matter, the sub-prime loans that we
      originate and purchase have loan to value (“LTV”) ratios that are less than 70%,
      as opposed to ratios of 95% or higher allowed by many sub-prime lenders. In
      addition, we do not offer so-called “teaser” rate adjustable loans, low or no
      document or “stated income” loans. Fourth, we do not generate or purchase high
      volumes of sub-prime loans, so we are able to look much more closely at the
      ability of individual borrowers to repay their loans. In the case of purchased
      loans, we rely on strict purchase criteria relating to LTV ratios and
      documentation. Notwithstanding the foregoing, we are subject to some exposure
      to
      losses because we do carry some sub-prime loans. For example, if real estate
      values in our markets continue to decline and our sub-prime borrowers were
      to
      default, the collateral securing these loans might not be sufficient to fully
      repay the loan balances. This risk applies equally to all of our
      loans.





**Critical
      Accounting Policies**





Our
      significant accounting policies are disclosed in Note A to the audited financial
      statements included in our Annual Report on Form 10-KSB for the year ended
      December 31, 2007. Management believes the following significant accounting
      policies also are considered critical accounting policies:





*Loan
      Impairment* –
A
      loan
      is considered impaired when, based on available information or current events,
      it is probable that we will be unable to collect scheduled payments of principal
      and interest when due according to the contractual terms of the loan agreement.
      Factors considered in determining impairment include payment status, collateral
      value, and the probability of collecting scheduled principal and interest
      payments when due. Loans that experience insignificant payment delays and
      payment shortfalls generally are not considered impaired. We measure impairment
      on a loan by loan basis using the present value of expected future cash flows
      discounted at the loan’s effective interest rate, the loan’s obtainable market
      value, or the fair value of the collateral if the loan is collateral-dependent.
      However, impairment is based on the fair value of the collateral if it is
      determined that the foreclosure is probable.





*Allowance
      for Loan Losses* –
We
      periodically evaluate the adequacy of the allowance for loan losses based on
      past loan loss experience, known and inherent risks in the portfolio, adverse
      situations that might affect the borrower’s ability to repay, the estimated
      value of any underlying collateral, and current economic conditions. While
      we
      use information available in establishing the allowance for loan losses,
      evaluation assessments are inherently subjective and future adjustments to
      the
      allowance may be necessary if economic conditions differ substantially from
      the
      assumptions used in making the evaluation. The allowance for loan losses is
      a
      material estimate that is particularly susceptible to significant change in
      the
      near term.





**Comparison
      of Financial Condition at September 30, 2008 and December 31,
      2007**





*Assets* .
      Total
      assets decreased by $5,633,011, from $53,392,939 at December 31, 2007 to
      $47,759,928 at September 30, 2008. The size of our loan portfolio, net of the
      allowance for loan losses, decreased $5,942,408 ending at $41,942,780. The
      decrease in total assets resulted primarily from our inability to sustain
      historical loan growth due to a shortage in cash because of our inability to
      sell our investor notes and the use of loan payoff proceeds to fund investor
      note redemption requests.





*Liabilities* .
      Total
      liabilities decreased by $4,868,740, from $52,353,873 at December 31, 2007
      to
      $47,485,133 at September 30, 2008. The net decrease was primarily due to
      $13,352,867 in investor note redemptions, offset by an increase of $4,804,058
      in
      loan participations sold.





*Equity* .
      Total
      stockholders’ equity decreased by $764,271 from $1,039,066 at December 31, 2007
      to $274,795 at September 30, 2008. The decrease was due to a net loss for the
      nine months ended September 30, 2008 of $474,844 related primarily to a decrease
      in net interest income because of a decrease in interest earning assets and
      a
      reduced net margin, as well as to stock-based compensation of $10,573 and the
      repurchase of 150,000 shares of stock at $2.00 per share.





*Past
      Due Loans* .
      As of
      September 30, 2008, we held 21 loans that were more than 90 days past due but
      still accruing interest, compared to 18 as of December 31, 2007. The total
      principal and interest due on these loans was $5,209,980, compared to $5,002,259
      as of December 31, 2007. Sixteen of the loans, totaling $4,114,295, are first
      mortgage loans on which we do not expect to suffer any loss due to the
      underlying real estate collateral values. One of the remaining five loans of
      $960,369 has a large second trust on three properties behind small first trusts.
      The borrowers under the remaining four loans, totaling $135,317, are making
      scheduled payments, and we continue to accrue interest on these loans based
      on
      the underlying collateral values and payment histories. We monitor these loans
      on a continuous basis.


-16-





*Non-Accrual
      Loans* .
      As of
      September 30, 2008, there were 17 loans in non-accrual status with an
      outstanding principal balance totaling $3,582,918, compared to 13 loans as
      of
      December 31, 2007 with an outstanding principal balance of $510,697. The
      majority of these loans are first mortgage loans that management believes are
      well-collateralized based on recent valuations. In the event we have to
      foreclose on any of these loans, we do not expect to recognize any loss in
      excess of specific reserves associated with the loans. As of September 30,
      2008,
      we had a specific reserve of $500,124 and a general reserve of $160,300 as
      part
      of our total reserve of $660,424 for anticipated and unanticipated loan
      losses.





**Comparison
      of Operating Results for Nine Months Ended September 30, 2008 and
      2007**





*Net
      interest margin.* The
      average yield earned on loans receivable was 9.91% for the nine months ended
      September 30, 2008 and 10.74% for the nine months ended September 30, 2007.
      The
      average rate paid on investor notes decreased to 6.72% for the nine months
      ended
      September 30, 2008 from 7.07% for the nine months ended September 30, 2007,
      due
      primarily to a decrease in the contractual rates we are required to pay on
      investor notes. Overall, the net margin on interest decreased to 3.19% for
      the
      nine months ended September 30, 2008, from 3.67% for the nine months ended
      September 30, 2007. This net margin is calculated using contractual rates and
      excludes fee income and expense.





*Net
      (Loss) Income* .
      Net
      loss for the nine months ended September 30, 2008 was $474,844, compared to
      net
      income of $82,537 for the nine months ended September 30, 2007. The difference
      was primarily due to a decrease in net interest income because of a decrease
      in
      interest earning assets and a reduced net interest rate margin as between
      interest-earning assets and interest-bearing liabilities.





*Interest
      Income* .
      Total
      interest income was $3,256,154 for the nine months ended September 30, 2008,
      compared to $4,568,795 for the same period in 2007. The decrease in interest
      income was due primarily to a decrease of $1,281,723 in interest earned on
      loans
      between the two periods because a significant amount of our higher-rate loans
      have been paid off. The decrease in interest earned on loans also resulted
      from
      a decline in our loans receivable portfolio due to normal payoffs and a lack
      of
      loan originations and purchases. Interest income includes loan and fee income
      and interest earned on bank investments and marketable securities.





*Interest
      Expense* .
      Interest expense was $2,677,945 for the nine months ended September 30, 2008,
      and $3,270,585 for the corresponding period in 2007. The decrease in interest
      expense was a result of a reduction in 2008 in interest rates that we pay on
      our
      interest-bearing liabilities and a reduction in total investor notes payable
      due
      to redemptions during the period. The interest expense includes the amortization
      of fees paid to brokers-dealers in prior periods for the sale of our investor
      notes.





*Provision
      for Loan Losses* .
      Our
      provision for loan losses was $272,384 for the nine months ended September
      30,
      2008, compared to $195,000 for the nine months ended September 30, 2007. These
      provisions increased the allowance for loan losses to an amount deemed by
      management to be sufficient to meet all anticipated loan losses plus a general
      amount to meet unforeseen loan losses. The adequacy of the allowance is
      periodically reviewed and adjusted by management based upon past experience,
      the
      value of the underlying collateral for specific loans, known or inherent risks
      in the loan portfolio and current economic conditions.





*Non-Interest
      Income* .
      We had
      non-interest income of $94,518 during the nine months ended September 30, 2008,
      compared to a loss of $18,800 for the corresponding period in 2007. The
      difference was primarily due to a loss of $52,567 on the sale of investment
      securities during the period ended September 30, 2007 and a substantial increase
      in rental income.





*Non-Interest
      Expense* .
      Non-interest expense decreased to $875,187 for the nine months ended September
      30, 2008 from $1,001,873 for the nine months ended September 30, 2007. The
      decrease was due to a reduction in salaries and wages, securities offering
      costs
      and professional fees.





*Income
      Taxes* .
      We have
      elected to be treated as a Subchapter S corporation under the Internal Revenue
      Code and, accordingly, no income tax expense appears in our financial
      statements.




**Comparison
      of Operating Results for Three Months Ended September 30, 2008 and
      2007**




*Net
      interest margin.* The
      average yield earned on loans receivable was 9.68% for the three months ended
      September 30, 2008 and 10.74% for the three months ended September 30, 2007.
      The
      average rate paid on investor notes decreased to 6.59% for the three months
      ended September 30, 2008 from 7.29% for the three months ended September 30,
      2007, due primarily to a decrease in the contractual rates we are required
      to
      pay on investor Notes. Overall, the net margin on interest decreased to 3.09%
      for the three months ended September 30, 2008, from 3.45% for the three months
      ended September 30, 2007. This net margin is calculated using contractual rates
      and excludes fee income and expense. The current net margin of 3.09% is at
      its
      historical low. The Company does not expect any further significant
      decrease.


-17-




*Net
      (Loss) Income* .
      Net
      loss for the three months ended September 30, 2008 was $181,941 compared to
      a
      net loss of $94,593 for the three months ended September 30, 2007. The
      difference was primarily due to a decrease in net interest income because of
      a
      decrease in interest earning assets and a reduced net interest rate margin
      as
      between interest-earning assets and interest-bearing liabilities.




*Interest
      Income* .
      Total
      interest income was $989,629 for the three months ended September 30, 2008,
      compared to $1,496,298 for the same period in 2007. The decrease in interest
      income resulted from a decrease in total loan portfolio due to loan payoffs
      and
      a lack of loan originations. The interest income includes point and fee income
      and interest earned on bank investments and marketable securities.




*Interest
      Expense* .
      Interest expense was $835,993 for the three months ended September 30, 2008,
      and
      $1,116,327 for the corresponding period in 2007. The decrease in interest
      expense was a result of a reduction in 2008 in interest rates that we pay on
      our
      interest-bearing liabilities and a reduction in total investor notes payable
      due
      to redemptions during the period. The interest expense includes the amortization
      of fees paid to brokers-dealers in prior periods for the sale of our investor
      notes.




*Provision
      for Loan Losses* .
      Our
      provision for loan losses was $118,286 for the three months ended September
      30,
      2008 and $75,000 for the three months ended September 30, 2007. These provisions
      increased the allowance for loan losses to an amount deemed by management to
      be
      sufficient to meet all anticipated loan losses plus a general amount to meet
      unforeseen loan losses. The adequacy of the allowance is periodically reviewed
      and adjusted by management based upon past experience, the value of the
      underlying collateral for specific loans, known or inherent risks in the loan
      portfolio and current economic conditions.




*Non-Interest
      Income* .
      We had
      non-interest income of $41,632 during the three months ended September 30,
      2008
      compared to a loss of $42,153 for the corresponding period in 2007. The
      difference was primarily due to a loss of $52,567 on the sale of securities
      during the 2007 period and a substantial increase in rental income.




*Non-Interest
      Expense* .
      We
      experienced a decrease in non-interest expense to $258,923 for the three months
      ended September 30, 2008 from $357,411 for the three months ended September
      30,
      2007. Decreases in salaries and wages and professional fees during the 2008
      period were the primary reasons for the decrease in non-interest expense.




*Income
      Taxes* .
      KH
      Funding Company has elected to be treated as a Subchapter S corporation under
      the Internal Revenue code and accordingly no income tax expense appears in
      the
      financial statements.





**Liquidity
      and Capital Resources**





At
      September 30, 2008, we had cash and cash equivalents of $12,366, or 0.02% of
      total assets, a historically low level, compared to $95,622 at December 31,
      2007
      (0.18% of total assets) and $165,723 (0.29% of total assets) at September 30,
      2007. During the first nine months of 2008, we received approximately $10.70
      million in loan payments (excluding interest), which included unscheduled
      prepayments and payments due at maturity, and we paid approximately $13.35
      million to redeem investor notes. During the same period of 2007, we received
      approximately $13.49 million in loan payments, and we paid approximately $17.41
      million to redeem investor notes.


.


For
      the
      nine months ended September 30, 2008, net cash provided by operating activities
      was $2,050,397, compared to $1,712,361 for the nine months ended September
      30,
      2007. The primary reason for the increase was a $662,496 reduction in interest
      receivable on loans as a result of loan payoffs during the period.





For
      the
      nine months ended September 30, 2008, net cash provided by investing activities
      was $4,467,070, compared to $3,320,631 for the same period in 2007. Cash
      provided by investing activities for the first three quarters of 2008 included
      $10,695,201 in principal repayments on loans receivable offset by $6,093,811
      in
      loans made to borrowers, compared to $13,489,339 and $10,999,358, respectively,
      for the first three quarters of 2007.





For
      the
      nine months ended September 30, 2008, net cash used in financing activities
      was
      $6,600,723, compared to $8,690,282 for the same period in 2007. During the
      2008
      period, net proceeds from loan participations sold of $4,804,058 were offset
      in
      part by $13,352,867 in investor note redemptions and $300,000 in stock
      repurchases.


-18-





We
      require cash and cash equivalents to fund and purchase loans and to satisfy
      redemption requests from holders of our outstanding investor notes.
      Historically, our primary sources of funding have been the proceeds from the
      sale of investor notes, principal and interest payments received on loans
      receivable and investments, proceeds from the sale of loans and rental income
      from real estate owned and held for rental. As discussed elsewhere in this
      report, we have been unable to raise cash for operations through the sale of
      our
      investor notes since the second quarter of 2006. Although a registration
      statement for the offer and sale of up to $250 million of our investor notes
      was
      declared effective on November 10, 2008, there can be no assurance that we
      will
      be able to raise a significant amount of cash from this offering for operations.
      Moreover, although maturities and scheduled amortization of loans receivable
      and
      investments are predictable sources of funds, the sale and redemption of
      investor notes and mortgage loan prepayments are greatly influenced by interest
      rate trends, economic conditions and competition.





Redemption
      requests from holders of our one-day and thirty day demand investor notes can
      cause significant volatility in our cash balances. Holders of our one day demand
      investor notes can request a redemption immediately after investment, and we
      are
      required to redeem the note within one day after receiving the request. Holders
      of our thirty day demand investor notes can likewise request a redemption
      immediately after investment, but we are required to redeem the note within
      30
      days after receiving the request. All other types of investor notes are
      redeemable upon maturity, or prior to maturity on 90 days advance notice,
      subject to a penalty. These features, along with our maximum investment
      guidelines, were designed to provide us with ample time to satisfy redemption
      requests. Under the Indenture related to our outstanding investor notes and
      the
      Notes, we will be in default if we fail to satisfy a redemption request within
      30 days of the date set for redemption, unless we obtain a waiver from each
      of
      the note holders who have requested redemption. Upon a default, for so long
      as
      such default is continuing, the Indenture Trustee and/or the holders of at
      least
      25% of the principal amount of our outstanding investor notes are permitted,
      but
      not required, to accelerate the maturity of all outstanding notes and take
      other
      actions permitted by the Indenture. Such an acceleration would likely require
      us
      to liquidate the Company.





When
      we
      sell an investor note, management determines how it wants to use the proceeds.
      Generally, our business strategy is to retain some of the proceeds as cash
      and
      cash equivalents and to use the remaining proceeds to fund loans and/or purchase
      other assets, such as mortgages and investment securities, that have higher
      yields than the yields that we pay on our investment notes. Unlike cash,
      however, investments in mortgages and securities may not always provide us
      with
      immediate liquidity. For example, we generally buy and originate more loans
      than
      are immediately saleable, but we try to structure our loan acquisitions so
      that
      they may be sold within our 30-day grace period for satisfying redemption
      requests. However, it must be noted that any sale of loans must comply with
      the
      requirements of the Trust Indenture Act of 1939 and may require the consent
      of
      the trustee for investor notes.





At
      September 30, 2008, we held approximately $25.47 million in residential and
      commercial mortgage loans that we believe could be sold within a short period
      of
      time for the purpose of satisfying investor note redemption requests. Further,
      we held $3.64 million in business line-of-credit loans and second lien loans
      at
      September 30, 2008, which earn higher yields than the first trust loans and
      that
      we believe could also be sold, although generally they take longer to sell
      and
      are sold at a discount. It should be noted, however, that the national and
      local
      real estate economies have weakened during the past two years in part due to
      the
      widely-reported problems in the sub-prime mortgage loan market. These problems
      have had the effect of decreasing the amount of credit that is available to
      borrowers. As a result, sellers of real estate and loans secured by real estate
      have found it more difficult in recent years to sell their assets at the times
      and at the prices they desire.





At
      September 30, 2008 and December 31, 2007, we had no available-for-sale
      investment securities, compared to $0 and $581,149 at September 30, 2007 and
      December 31, 2006, respectively. The decline in available-for-sale securities
      resulted primarily from the sale of these securities during 2007 to fund
      operations and the fact we are not actively investing in marketable securities
      because we are using our available cash to satisfy redemption requests. Assuming
      that market conditions warrant investment activities, we expect to begin
      investing in marketable securities again when our cash position
      improves.





Because
      of the legal and market factors discussed above, we may not be able to sell
      loans or other assets to meet redemption requests within the 30-day grace
      period. The balances of our outstanding investor notes at September 30, 2008
      are
      as follows:





**Series
                3 Demand Notes**
            
            **Balance**One
                Day
            
            $
            5,671,566Thirty
                Day
            
            $
            8,575,495**Series
                3 Fixed Term Notes:**Due
                within 1 year
            
            $
            7,564,006Due
                in 1 to 3 years
            
            $
            5,790,997Due
                in 3 to 5 years
            
            $
            6,570,350


-19-





**Series
                4 Fixed Term Notes:**Due
                within 1 year
            
            $
            1,761,991Due
                in 1 to 3 years
            
            $
            354,065Due
                in 3 to 5 years
            
            $
            4,477,238Subtotal
            
            $
            40,765,708Unamortized
                brokerage costs
            
            
            (81,533
            )Total
                investor notes, net
            
            $
            40,684,175





We
      recently satisfied $1.89 million in investor note redemption requests that
      had
      been outstanding more than 30 days after the date set for redemption. Redemption
      requests by three holders (totaling approximately $975,553) remain unsatisfied
      more than 30 days after the date set for redemption, but each of these investors
      is a holder of our common stock and has waived timely payment. In addition,
      as
      of the filing date of this report we were subject to redemption requests with
      respect to approximately $1.04 million of outstanding investor notes that are
      within the 30-day grace period for repayment. We expect to be able to satisfy
      these requests within the applicable grace periods using cash received from
      sales of our investor notes and cash received from loan payoffs and other
      operations.




**Known
      Trends, Events of Uncertainties**





*Impact
      of Inflation and Interest Rates* .
      The
      financial statements of the Company and notes thereto, presented elsewhere
      herein, have been prepared in accordance with accounting principles generally
      accepted in the United States of America, which require the measurement of
      financial position and operating results in terms of historical dollars without
      considering the change in the relative purchasing power of money over time
      and
      due to inflation. The impact of inflation is generally to increase the value
      of
      underlying collateral for the loans made by the Company to its borrowers. Unlike
      typical industrial companies, nearly all the assets and liabilities of the
      Company are monetary in nature. As a result, interest rates have a greater
      impact on our performance than the effects of inflation generally.





*Stockholders’
      Equity* .
      Total
      stockholders’ equity has decreased as a percentage of total assets over the last
      seven years, from 10.6% at December 31, 1999 to 0.58% at September 30, 2008.
      During the period ending September 30, 2008, we experienced an operating loss
      of
      $474,844 combined with stock repurchases of $300,000 resulting in an ending
      balance in stockholders equity of $274,795. Our Board suspended the payment
      of
      stock dividends after the second quarter of 2007 to help maintain sufficient
      equity levels.





**Item
      4T. Controls and Procedures.**





We
      maintain disclosure controls and procedures that are designed to ensure that
      information required to be disclosed in our reports filed under the Securities
      Exchange Act of 1934 with the SEC, such as this Quarterly Report, is recorded,
      processed, summarized and reported within the time periods specified in those
      rules and forms, and that such information is accumulated and communicated
      to
      Management, including the Chief Executive Officer, who also serves as the acting
      Chief Financial Officer (“CFO”), to allow for timely decisions regarding
      required disclosure. A control system, no matter how well conceived and
      operated, can provide only reasonable, not absolute, assurance that the
      objectives of the control system are met. Further, the design of a control
      system must reflect the fact that there are resource constraints, and the
      benefits of controls must be considered relative to their costs. 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 system of controls also is based in part upon certain
      assumptions about the likelihood of future events, and there can be no assurance
      that any design will succeed in achieving its stated goals under all potential
      future conditions; over time, control may become inadequate because of changes
      in conditions, or the degree of compliance with the policies or procedures
      may
      deteriorate.





An
      evaluation of the effectiveness of these disclosure controls as of September
      30,
      2008 was carried out under the supervision and with the participation of
      Management, including the CEO. Based on that evaluation, the Company’s
      management, including the CEO, has concluded that our disclosure controls and
      procedures are, in fact, effective at the reasonable assurance level.





During
      the third quarter of 2008, there was no change in our internal control over
      financial reporting that has materially affected, or is reasonably likely to
      materially affect, our internal control over financial reporting. As reported
      in
      our Annual Report on Form 10-KSB for the year ended December 31, 2007,
      management identified as a material deficiency in internal control over
      financial reporting the fact that our President also servers as our principal
      accounting officer. Although we will continue to evaluate and monitor the
      potential impact that this deficiency presents, our present intention is to
      not
      hire a separate principal accounting officer unless and until our revenue and
      net income levels warrant such a change. Efforts to evaluate, and remediate
      when
      necessary, the previously reported changes to our internal control over
      financial reporting to address the other weaknesses described in our Annual
      Report on Form 10-KSB are continuing and are expected to continue throughout
      fiscal 2008 and beyond.


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**PART
      II – OTHER INFORMATION**





**Item
      1. Legal Proceedings**





On
      November 6, 2008, we received a copy of a complaint that was purportedly filed
      on October 31, 2008 by Samar Ghadry in Montgomery County, Maryland Circuit
      Court
      against us, Prime Global Securities, Inc., Forum Trading Corp., FTC Capital
      Markets, Inc., FTC Group, Inc., Pension Financial Services, Inc., Martin Angeli,
      and Sonia Aguirre Pietri De Angeli. We have not been served with legal process.
      This litigation relates to the actions of Martin Angeli, our former Senior
      Vice
      President, discussed above in the risk factor entitled “We are subject to
      pending litigation the outcome of which could have a material adverse impact
      on
      us”. In her complaint, Ms. Ghadry alleges that she and Mr. Angeli entered into
      a
      stock selling agreement whereby Mr. Angeli agreed to sell securities for her
      at
      $2.00 per share, but actually sold them at $2.50 per share and retained the
      excess, which amounted to $864,298.20. Although Ms. Ghadry alleges that we
      were
      also a party to this stock selling agreement, we have no knowledge of any such
      agreement nor was any officer of KH Funding authorized to execute such an
      agreement on our behalf. Ms. Ghadry further alleges that Mr. Angeli caused
      these
      excess funds to be wired to an investor account at KH Funding held by his
      mother, Sonia Aguirre Pietri De Angeli, and then to an account at another
      institution also held by his mother, thereby depriving Ms. Ghadry of these
      funds. Ms. Ghadry alleges that Mr. Angeli forged her signature on the initial
      wire authorization and that one of our employees notarized that signature,
      and
      that our actions, or failures to act, with respect to these wire transactions
      and our supervision of Mr. Angeli make us liable to her. The
      wire
      transaction report we received did not indicate the account for which the funds
      were earmarked, but because Mr. Angeli had apprised us that his mother intended
      to make this investment we relied on him for confirmation of the wire and
      deposited the funds into his mother’s account. Although we subsequently
      confirmed that the wire instructions did in fact reference the account of Mr.
      Angeli’s mother, we have also learned that the instructions seem to indicate
      that the funds were intended for further credit to Ms. Ghadry. We have been
      unable to confirm any of these allegations or that any wrongdoing actually
      took
      place. Ms. Ghadry’s claims
      against us include breach of contract, fraud, breach of fiduciary duty,
      conversion, negligent supervision, negligence, re-credit of account for
      unauthorized transfers, aiding and abetting conversion, aiding and abetting
      fraud, and aiding and abetting breach of fiduciary duty. Ms. Ghadry seeks
      compensatory damages from us in the amount of $864,298.20 and punitive damages
      from us in the amount of $5.0 million, plus costs and interest. We believe
      that
      we have strong defenses to these claims and intend to vigorously defend this
      lawsuit, although we cannot predict the outcome of this litigation or its
      financial impact on us. We have insurance policies in place that we believe
      would provide coverage for up to $3.0 million, but there can be no assurance
      that our policies will cover any or all of these claims.





We
      are at
      times, in the ordinary course of business, a party to legal actions normally
      associated with a lending institution. Management does not believe that any
      pending normal course litigation is likely to have a material adverse impact
      on
      us.





**Item
      6. Exhibits**





The
      Exhibits filed or furnished with this report are listed in the Exhibit Index
      which immediately follows the signatures to this report, and this Exhibit Index
      is incorporated herein by reference.





**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.





KH
                FUNDING COMPANY(Registrant)Dated:
                November 13, 2008
            /s/
                Robert L. HarrisRobert
                L. HarrisPresident,
                Chief Executive Officer, and Acting Chief Financial Officer


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**EXHIBIT
      INDEX**





Exhibit
            
            Description31.1
            
            Certifications
                of the CEO and CFO pursuant to Section 302 of the Sarbanes-Oxley
                Act
                (filed herewith).32.1
            
            Certification
                of the CEO and CFO pursuant to Section 906 of the Sarbanes-Oxley
                Act
                (furnished herewith).


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