**U.S. SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

** **

----

** **

**FORM 10-QSB**

 

----

 

**x**                              QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF1934

** **

**For the quarterly periodended March 31, 2007**

** **

**Commission File Number333-124155**

** **

----

 

**KH FUNDING COMPANY**

(Exact name of small business issuer as specified inits charter)

 

| **Maryland**                                                      |   | **6162**                                                   |   | **52-1886133**                          |
|-------------------------------------------------------------------|--------|------------------------------------------------------------|--------|-----------------------------------------|
| (State or other  jurisdiction of   incorporation or organization) |   | (Primary  Standard Industrial  Classification Code Number) |   | (I.R.S. Employer    Identification No.) |

 

**10801 Lockwood Drive,Suite 370**

**Silver Spring, Maryland20901**

**(301) 592-8100**

(Address and telephone number of principal executiveoffice)

 

Check whether the issuer (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the past 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. YES x   NO o

State the number ofshares outstanding of each of the issuer’s class of Common Stock as of thelatest practicable date.

 

| **Class**                                |   | **Outstanding  as of May 20, 2007** |
|------------------------------------------|--------|-------------------------------------|
| Common Stock,  $0.01 par value per share |   | 2,727,281                           |

 

Transitional Small Business Disclosure Format (CheckOne): YES o   NO x

 

----

 

**PART I — FINANCIALINFORMATION**

|                                                                                                             | ** ** | **PAGE NOS.** |
|-------------------------------------------------------------------------------------------------------------|------------|---------------|
| ** **                                                                                                  | ** ** | ** **    |
| **ITEM 1.  financial statements**                                                                           | ** ** | ** **    |
| ** **                                                                                                  | ** ** | ** **    |
| BALANCE SHEETS — March 31, 2007 (UNAUDITED) and  December 31, 2006                                     |       | 3             |
|                                                                                                        |       |          |
| STATEMENTS OF OPERATIONS (UNAUDITED), three months  ended March 31, 2007 and 2006                           |       | 4             |
|                                                                                                        |       |          |
| STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY  (UNAUDITED), three months ended March 31, 2007 and 2006 |       | 5             |
|                                                                                                        |       |          |
| STATEMENTS OF CASH FLOWS (UNAUDITED), three months  ended March 31, 2007 and 2006                           |       | 6             |
|                                                                                                        |       |          |
| NOTES TO INTERIM FINANCIAL STATEMENTS (UNAUDITED)                                                           |       | 7–12     |

 

2

----

**KHFUNDING COMPANY**

**BALANCE SHEETS**
| ** **                                                                                                           | ** ** | **March 31,  2007** | ** ** | **December 31,  2006** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                                                                                                           | ** ** | **(unaudited)**          | ** ** | ** **                  | ** ** |
| **Assets**                                                                                                           |       |                     |       |                        |       |
| Cash                                                                                                                 |       | $                        | 1,625,414  |                        | $          | 3,823,013 |   |
| Investments  available for sale:                                                                                     |       |                     |       |                        |       |
| Marketable  securities — at fair value                                                                          |       | 594,006                  |       | 581,149                     |       |
| Other                                                                                                                |       | 50,872                   |       | 50,872                      |       |
| Loans, less  allowance for loan losses of $344,516 (March 31, 2007) and  $452,154 (December 31, 2006) |       | 56,274,466               |       | 54,704,020                  |       |
| Accrued interest  receivable                                                                                         |       | 2,136,443                |       | 1,961,683                   |       |
| Other  receivables                                                                                                   |       | 70,432                   |       | 611,397                     |       |
| Prepaid expenses                                                                                                     |       | 276,887                  |       | 294,496                     |       |
| Property and  equipment — Net                                                                                   |       | 141,011                  |       | 143,419                     |       |
| Real estate  owned:                                                                                                  |       |                     |       |                        |       |
| Rental property                                                                                                      |       | 810,347                  |       | 814,441                     |       |
| Held for sale                                                                                                        |       | 632,145                  |       | 325,223                     |       |
| Other assets                                                                                                         |       | 15,989                   |       | 15,988                      |       |
|                                                                                                                 |       |                     |       |                        |       |
| **Total Assets**                                                                                                     |       | $                        | 62,628,012 |                        | $          | 63,325,701 |   |
| ** **                                                                                                           |       |                     |       |                        |       |
| **Liabilities and Stockholders’  Equity**                                                                       |       |                     |       |                        |       |
| ** **                                                                                                           |       |                     |       |                        |       |
| **Liabilities**                                                                                                      |       |                     |       |                        |       |
| Notes and  accrued interest payable                                                                                  |       | $                        | 53,299,293 |                        | $          | 61,774,343 |   |
| Other loans  payable                                                                                                 |       | 7,714,067                |       | —                      |       |
| Accounts payable  and accrued expenses                                                                               |       | 29,411                   |       | 21,980                      |       |
| Escrows and  security deposits                                                                                       |       | 119,126                  |       | 111,064                     |       |
|                                                                                                                 |       |                     |       |                        |       |
| **Total Liabilities**                                                                                                |       | 61,161,897               |       | 61,907,387                  |       |
| ** **                                                                                                           |       |                     |       |                        |       |
| **Stockholders’ Equity**                                                                                        |       |                     |       |                        |       |
| Common stock  (5,000,000 shares authorized; 2,726,951 shares issued and outstanding,  $0.01 par value)     |       | 27,269                   |       | 27,269                      |       |
| Paid-in capital                                                                                                      |       | 1,832,745                |       | 1,879,783                   |       |
| Accumulated  deficit                                                                                                 |       | (184,756                 | )          | (269,120                    | )          |
| Subscription  note receivable                                                                                        |       | (185,450                 | )          | (185,450                    | )          |
| Accumulated  other comprehensive loss                                                                                |       | (23,693                  | )          | (34,168                     | )          |
|                                                                                                                 |       |                     |       |                        |       |
| **Total Stockholders’ Equity**                                                                                  |       | 1,466,115                |       | 1,418,314                   |       |
| ** **                                                                                                           |       |                     |       |                        |       |
| **Total Liabilities and Stockholders’ Equity**                                                                  |       | $                        | 62,628,012 |                        | $          | 63,325,701 |   |

 

*Theaccompanying notes are an integral part of these statements.*

3

----

**KH FUNDING COMPANY**

**STATEMENTS OFOPERATIONS (UNAUDITED)**
| ** **                                           | ** ** | **For The Three Months  Ended March 31,** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                           | ** ** | **2007**                                                           | ** ** | **2006** | ** ** |
| **Interest  Income**                                 |       |                                                               |       |   |   |
| Interest and fees on loans                           |       | $                                                                  | 1,515,829  |   | $ | 1,260,203 |   |
| Interest on bank accounts                            |       | 5,334                                                              |       | 43,065 |   |
| Interest on investments — marketable securities |       | 11,382                                                             |       | 7,727 |   |
|                                                 |       |                                                               |       |   |   |
| Total interest income                                |       | 1,532,545                                                          |       | 1,310,995 |   |
|                                                 |       |                                                               |       |   |   |
| **Interest  Expense**                                |       |                                                               |       |   |   |
| Interest and fees on notes                           |       | 1,006,434                                                          |       | 851,979 |   |
|                                                 |       |                                                               |       |   |   |
| Interest on other loans                              |       | 77,883                                                             |       | — |   |
|                                                 |       |                                                               |       |   |   |
| Total interest expense                               |       | 1,084,317                                                          |       | 851,979 |   |
|                                                 |       |                                                               |       |   |   |
| Net interest income                                  |       | 448,228                                                            |       | 459,016 |   |
|                                                 |       |                                                               |       |   |   |
| **Provision  for Loan Losses**                       |       | 45,000                                                             |       | 57,352 |   |
|                                                 |       |                                                               |       |   |   |
| Net interest income after provision for loan losses  |       | 403,228                                                            |       | 401,664 |   |
|                                                 |       |                                                               |       |   |   |
| **Non-interest  Income**                             |       |                                                               |       |   |   |
| Rental income                                        |       | 14,105                                                             |       | 10,516 |   |
| Other                                                |       | 2,968                                                              |       | 5,144 |   |
|                                                 |       |                                                               |       |   |   |
| Total non-interest income                            |       | 17,073                                                             |       | 15,660 |   |
|                                                 |       |                                                               |       |   |   |
| **Non-interest  Expense**                            |       |                                                               |       |   |   |
| Salaries and wages                                   |       | 120,687                                                            |       | 95,608 |   |
| Professional fees                                    |       | 30,477                                                             |       | 29,448 |   |
| Offering costs                                       |       | 47,402                                                             |       | 56,208 |   |
| Administration                                       |       | 38,707                                                             |       | 37,617 |   |
| Real estate maintenance                              |       | 24,575                                                             |       | 20,400 |   |
| Insurance                                            |       | 12,567                                                             |       | 19,385 |   |
| Depreciation                                         |       | 14,045                                                             |       | 14,863 |   |
| Rent                                                 |       | 29,005                                                             |       | 31,815 |   |
| Bank charges                                         |       | 8,640                                                              |       | 6,444 |   |
| Other                                                |       | 9,832                                                              |       | 10,402 |   |
|                                                 |       |                                                               |       |   |   |
| Total non-interest expense                           |       | 335,937                                                            |       | 322,190 |   |
|                                                 |       |                                                               |       |   |   |
| **Net  Income**                                      |       | $                                                                  | 84,364     |   | $ | 95,134 |   |
|                                                 |       |                                                               |       |   |   |
| Basic earnings per share                             |       | $                                                                  | 0.03       |   | $ | 0.04 |   |
| Diluted earnings per share                           |       | $                                                                  | 0.03       |   | $ | 0.04 |   |
| Cash dividends  paid per common share                |       | $                                                                  | 0.02       |   | $ | 0.02 |   |

 

*Theaccompanying notes are an integral part of these statements.*

4

----

**KH FUNDING COMPANY**

**STATEMENTSOF CHANGES IN STOCKHOLDERS’ EQUITY (UNAUDITED)FOR THE THREE MONTHS ENDED MARCH 31, 2007 and 2006**
| ** **                                     | ** ** | **Common Stock** | ** ** | **Paid-In** | ** ** | **Accumulated** | ** ** | **Subscription  Note** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Total  Stockholders’** | ** ** |
|------------------------------------------------|------------|-----------------------|------------|-------------|------------|-----------------|------------|------------------------|------------|---------------------------------------|------------|-------------------------------|------------|
| ** **                                     | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**     | ** ** | **Deficit**            | ** ** | **Receivable**                        | ** ** | **(Loss) Income**        | ** ** | **Equity** | ** ** |
| ** **                                     | ** ** | ** **            | ** ** | ** **  | ** ** | ** **      | ** ** | ** **             | ** ** | ** **                            | ** ** | ** **                    | ** ** | ** ** | ** ** |
| **Balances  at January 1, 2006**               |       | 2,555,556             |       | $           | 25,556     |            | $          | 1,603,852              |       | $                                     | (429,688   | )                             | $          | (185,450 | ) | $ | (99,463 | ) | $ | 914,807 |   |
|                                           |       |                  |       |        |       |            |       |                   |       |                                  |       |                          |       |   |   |
| **Additional  stock issued**                   |       | 141,070               |       | 1,411       |       | 381,799         |       | —                 |       | —                                |       | —                        |       | 383,210 |   |
| **Dividend  declared**                         |       | —                |       | —      |       | (51,110         | )          | —                 |       | —                                |       | —                        |       | (51,110 | ) |
| **Stock-based  compensation**                  |       | 3,325                 |       | 33          |       | 9,942           |       | —                 |       | —                                |       | —                        |       | 9,975 |   |
| ** **                                     | ** ** | ** **            | ** ** | ** **  | ** ** | ** **      | ** ** | ** **             | ** ** | ** **                            | ** ** | ** **                    | ** ** | ** ** | ** ** |
| **Comprehensive  income**                      | ** ** | ** **            | ** ** | ** **  | ** ** | ** **      | ** ** | ** **             | ** ** | ** **                            | ** ** | ** **                    | ** ** | ** ** | ** ** |
| Net income for period ended March 31, 2006     |       | —                |       | —      |       | —          |       | 95,134                 |       | —                                |       | —                        |       | 95,134 |   |
| Change in fair value of investments            |       | —                |       | —      |       | —          |       | —                 |       | —                                |       | 28,248                        |       | 28,248 |   |
|                                           |       |                  |       |        |       |            |       |                   |       |                                  |       |                          |       |   |   |
| **Total  Comprehensive Income for the Period** |       | —                |       | —      |       | —          |       | —                 |       | —                                |       | —                        |       | 123,382 |   |
|                                           |       |                  |       |        |       |            |       |                   |       |                                  |       |                          |       |   |   |
| **Balances  at March 31, 2006**                |       | 2,699,951             |       | $           | 27,000     |            | $          | 1,944,483              |       | $                                     | (334,554   | )                             | $          | (185,450 | ) | $ | (71,215 | ) | $ | 1,380,264 |   |
|                                           |       |                  |       |        |       |            |       |                   |       |                                  |       |                          |       |   |   |
| **Balances  at January 1, 2007**               |       | 2,726,951             |       | $           | 27,269     |            | $          | 1,879,783              |       | $                                     | (269,120   | )                             | $          | (185,450 | ) | $ | (34,168 | ) | $ | 1,418,314 |   |
| ** **                                     | ** ** | ** **            | ** ** | ** **  | ** ** | ** **      | ** ** | ** **             | ** ** | ** **                            | ** ** | ** **                    | ** ** | ** ** | ** ** |
| **Dividend  declared**                         |       | —                |       | —      |       | (54,538         | )          | —                 |       | —                                |       | —                        |       | (54,538 | ) |
| **Stock-based  compensation**                  |       |                  |       |        |       | 7,500           |       |                   |       |                                  |       |                          |       | 7,500 |   |
| ** **                                     | ** ** | ** **            | ** ** | ** **  | ** ** | ** **      | ** ** | ** **             | ** ** | ** **                            | ** ** | ** **                    | ** ** | ** ** | ** ** |
| **Comprehensive  income**                      | ** ** | ** **            | ** ** | ** **  | ** ** | ** **      | ** ** | ** **             | ** ** | ** **                            | ** ** | ** **                    | ** ** | ** ** | ** ** |
| Net income for period ended March 31, 2007     |       | —                |       | —      |       | —          |       | 84,364                 |       | —                                |       | —                        |       | 84,364 |   |
| Change in fair value of investments            |       | —                |       | —      |       | —          |       | —                 |       | —                                |       | 10,475                        |       | 10,475 |   |
|                                           |       |                  |       |        |       |            |       |                   |       |                                  |       |                          |       |   |   |
| **Total  Comprehensive Income for the Period** |       | —                |       | —      |       | —          |       | —                 |       | —                                |       | —                        |       | 94,839 |   |
| ** **                                     | ** ** | ** **            | ** ** | ** **  | ** ** | ** **      | ** ** | ** **             | ** ** | ** **                            | ** ** | ** **                    | ** ** | ** ** | ** ** |
| **Balances at March 31, 2007**                 |       | 2,726,951             |       | $           | 27,269     |            | $          | 1,832,745              |       | $                                     | (184,756   | )                             | $          | (185,450 | ) | $ | (23,693 | ) | $ | 1,466,115 |   |

 

*Theaccompanying notes are an integral part of these statements.*

5

----

**KH FUNDING COMPANY**

**STATEMENTS OF CASHFLOWS (UNAUDITED)**
| ** **                                                                     | ** ** | **For The Three Months Ended March 31,** | ** ** |
|--------------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                                                     | ** ** | **2007**                                                               | ** ** | **2006** | ** ** |
| **Cash  from Operating Activities**                                            | ** ** | ** **                                                             | ** ** | ** ** | ** ** |
| Net income (loss)                                                              |       | $                                                                      | 84,364     |   | $ | 95,134 |   |
| **Adjustments  to reconcile net income to net cash from operating activities** | ** ** | ** **                                                             | ** ** | ** ** | ** ** |
| Depreciation                                                                   |       | 14,045                                                                 |       | 14,863 |   |
| Amortization of loan fees                                                      |       | (27,000                                                                | )          | (30,000 | ) |
| Provision for loan losses                                                      |       | 45,000                                                                 |       | 57,352 |   |
| Stock-based compensation expense                                               |       | 7,500                                                                  |       | 9,975 |   |
| (Increase) decrease in accrued late charges                                    |       | (2,954                                                                 | )          | (5,175 | ) |
| (Increase) decrease in prepaid expenses                                        |       | (8,811                                                                 | )          | 20,960 |   |
| Increase in interest receivable                                                |       | (165,760                                                               | )          | (28,322 | ) |
| Increase in interest payable (included in notes payable)                       |       | 670,409                                                                |       | 546,561 |   |
| (Decrease) increase in accounts payable and accrued expenses                   |       | 3,654                                                                  |       | (415 | ) |
| Accrued interest on investments                                                |       | (9,000                                                                 | )          | (7,728 | ) |
| Decrease (increase) in prepaid offering costs                                  |       | 26,420                                                                 |       | 56,208 |   |
| Deferred loan origination costs                                                |       | 3,000                                                                  |       | (7,491 | ) |
| Unamortized brokerage fees                                                     |       | 7,784                                                                  |       | (80,922 | ) |
| Long term lease liability                                                      |       | 3,777                                                                  |       | 7,863 |   |
| Prepaid loan expenses                                                          |       | 2,053                                                                  |       | (48,917 | ) |
|                                                                           |       |                                                                   |       |   |   |
| **Net  Cash Provided by Operating Activities**                                 |       | 654,481                                                                |       | 599,946 |   |
|                                                                           |       |                                                                   |       |   |   |
| **Cash  Flows from Investing Activities**                                      | ** ** | ** **                                                             | ** ** | ** ** | ** ** |
| Principal repayments from borrowers                                            |       | 2,571,917                                                              |       | 8,377,164 |   |
| Loans made to borrowers                                                        |       | (4,469,384                                                             | )          | (14,352,116 | ) |
| Purchase of marketable securities and other  investments                       |       | (2,382                                                                 | )          | (428 | ) |
| Payments for other receivables                                                 |       | 576,422                                                                |       | 99,548 |   |
| Purchase of property and equipment                                             |       | (7,044                                                                 | )          | (5,828 | ) |
| Payments on other real estate owned                                            |       | (500                                                                   | )          | (7,148 | ) |
|                                                                           |       |                                                                   |       |   |   |
| **Net  Cash Used in Investing Activities**                                     |       | (1,330,971                                                             | )          | (5,888,808 | ) |
|                                                                           |       |                                                                   |       |   |   |
| **Cash  Flows from Financing Activities**                                      | ** ** | ** **                                                             | ** ** | ** ** | ** ** |
| Proceeds from investor notes                                                   |       | 898,276                                                                |       | 37,002,763 |   |
| Proceeds from other loans                                                      |       | 16,952,001                                                             |       | 31,500 |   |
| Principal payments on investor notes                                           |       | (10,081,768                                                            | )          | (30,329,599 | ) |
| Payments on other loans                                                        |       | (9,237,935                                                             | )          | — |   |
| Increase (decrease) in unapplied deposits                                      |       | 30,250                                                                 |       | — |   |
| Proceeds from sales of common stock                                            |       | —                                                                 |       | 354,485 |   |
| Payment of dividends                                                           |       | (54,538                                                                | )          | (51,110 | ) |
| (Decrease) Increase in escrow and security deposits                            |       | (27,395                                                                | )          | (3,481 | ) |
|                                                                           |       |                                                                   |       |   |   |
| **Net  Cash (Used) Provided by Financing Activities**                          |       | (1,521,109                                                             | )          | 7,004,558 |   |
|                                                                           |       |                                                                   |       |   |   |
| **Net  (Decrease) Increase in Cash**                                           |       | (2,197,599                                                             | )          | 1,715,696 |   |
|                                                                           |       |                                                                   |       |   |   |
| **Cash  Balance, beginning of period**                                         |       | 3,823,013                                                              |       | 6,579,242 |   |
| ** **                                                                     | ** ** | ** **                                                             | ** ** | ** ** | ** ** |
| **Cash  Balance, end of period**                                               |       | $                                                                      | 1,625,414  |   | $ | 8,294,938 |   |
|                                                                           |       |                                                                   |       |   |   |
| **Supplemental  Cash Flow Information**                                        | ** ** | ** **                                                             | ** ** | ** ** | ** ** |
| Interest paid                                                                  |       | $                                                                      | 413,908    |   | $ | 305,885 |   |
| Transfer of  loans to other real estate owned                                  |       | $                                                                      | 306,922    |   | $ | — |   |

 

*Theaccompanying notes are an integral part of these statements.*

6

----

**KHFUNDING COMPANY**

**NOTESTO INTERIM FINANCIAL STATEMENTS (UNAUDITED)FOR THE THREE MONTHS ENDED MARCH 31, 2007 and 2006**

**NOTE A—BASIS OF PRESENTATION**

The information containedin 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.

The financial statementsof KH Funding for the three month periods ended March 31, 2007 and 2006 areunaudited and include all adjustments which, in the opinion of management, arenecessary to present fairly the financial condition and results of operationsas of and for the periods then ended. All such adjustments are of a normal andrecurring nature.

The accompanyingunaudited financial statements have been prepared in conformity with generallyaccepted accounting principles in the United States (“GAAP”) for interimfinancial information, as well as in accordance with the instructions to Form10-QSB. Accordingly, the information and footnotes required by GAAP for non-interim,or complete financial statements are not included. Operating results for theinterim periods reflected do not necessarily indicate the results that may beexpected for a full fiscal year.  Thesefinancial statements should be read in conjunction with the financialstatements contained in the Company’s Form 10-KSB for the year ended December31, 2006 filed with the Securities and Exchange Commission on April 6, 2007.

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

#### **CriticalAccounting Policies and Estimates**

Note A of the Notes toFinancial Statements in our Annual Report on Form 10-KSB for the year endedDecember 31, 2006 describes the significant accounting policies used in thepreparation of the Company’s financial statements. In preparing financialstatements in conformity with accounting principles generally accepted in theUnited States of America, management is required to make estimates andassumptions that affect the reported amounts of assets and liabilities and thedisclosure of contingent assets and liabilities at the date of the financialstatements and revenue and expenses during the reporting period. Actual resultscould differ from those estimates.

#### **Natureof Operation**

TheCompany conducts operations from its headquarters in Silver Spring, Maryland.Its primary business activities consist of originating, acquiring and servicingmortgage loans, and issuing interest-bearing debt securities to investors.  The Company purchases first and second trustresidential loans nationwide from other lenders and banks. The Company alsodirectly originates small commercial real estate mortgage loans and investmentproperty residential mortgage loans.

#### **Useof Estimates in Preparing Financial Statements**

In preparing financialstatements in conformity with accounting principles generally accepted in theUnited States of America, management is required to make estimates andassumptions that affect the reported amounts of assets and liabilities and thedisclosure of contingent assets and liabilities at the date of the financialstatements and revenue and expenses during the reporting period. Actual resultscould differ from those estimates.

#### **EarningsPer Share**

Basic earnings per shareis derived by dividing net income available to common stockholders by theweighted-average number of common shares outstanding and does not include theeffect of any potentially dilutive common stock equivalents. Diluted earningsper share is derived by dividing net income by the weighted-average number ofshares outstanding, adjusted for the dilutive effect of outstanding stockoptions. As of March 31, 2007 and March 31, 2006 the Company had 471,250 and321,250 options outstanding, respectively. For the three months ended March 31,2007 and 2006 50,000 and 0 options, respectively, were excluded from thecomputation of dilutive earnings per share as their effect would have beenanti-dilutive.

7

----

 
| ** **                                                 | ** ** | **For the Three Months Ended March 31,** | ** ** |
|------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                                 | ** ** | **2007**                                                               | ** ** | **2006** | ** ** |
| ** **                                                 | ** ** | **(unaudited)**                                                        | ** ** | **(unaudited)** | ** ** |
| Basic:                                                     |       |                                                                   |       |   |   |
| Net income  (attributable to common stock)                 |       | $                                                                      | 84,364     |   | $ | 95,134 |   |
| Weighted average  common shares outstanding                |       | 2,726,951                                                              |       | 2,574,236 |   |
| Basic earnings  per share                                  |       | $                                                                      | 0.03       |   | $ | 0.04 |   |
|                                                       |       |                                                                   |       |   |   |
| Diluted:                                                   |       |                                                                   |       |   |   |
| Net income  (attributable to common stock)                 |       | $                                                                      | 84,364     |   | $ | 95,134 |   |
| Weighted average  common shares outstanding                |       | 2,726,951                                                              |       | 2,574,236 |   |
| Dilutive effect  of stock options                          |       | 98,750                                                                 |       | 111,490 |   |
| Weighted average  common shares outstanding — diluted |       | 2,825,701                                                              |       | 2,685,726 |   |
| Diluted earnings per  share                                |       | $                                                                      | 0.03       |   | $ | 0.04 |   |

 

**Income Taxes**

The Company has electedunder the Internal Revenue Code to be treated as an “S Corporation.”  As such the corporate income is taxed toindividual shareholders based upon their proportionate share of the Company’staxable income.  Therefore, no provisionfor corporate Federal or State income taxes need be included in the Company’sfinancial statements.

**New Accounting Pronouncements**

In February 2006, the Financial Accounting StandardsBoard (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No.155, *“Accounting for Certain HybridFinancial Instruments”*, an amendment of SFAS No. 133 and SFAS No.140. This statement permits fair value re-measurement for any hybrid financialinstrument that contains an embedded derivative that otherwise would requirebifurcation. It establishes a requirement to evaluate interests in securitizedfinancial assets to identify interests that are freestanding derivatives orthat are hybrid financial instruments that contain an embedded derivativerequiring bifurcation. In addition, SFAS 155 clarifies that interest-onlystrips and principal-only strips are not subject to the requirements ofStatement 133. It also clarifies that concentrations of credit risk in the formof subordination are not embedded derivatives. SFAS 155 amends Statement 140 toeliminate the prohibition on a qualifying special purpose entity from holding aderivative financial instrument that pertains to a beneficial interest otherthan another derivative financial instrument. This Statement is effective forall financial instruments acquired or issued after the beginning of an entity’sfirst fiscal year that begins after September 15, 2006. The Company does notpresently have any derivative instruments and believes this new accountingstandard has no impact on its financial condition or results of operation.

In March 2006, the FASB issued SFAS No. 156, *“Accounting for Servicing of Financial Assets”.*This Statement amends SFAS No. 140, *“Accountingfor Transfers and Servicing of Financial Assets and Extinguishments ofLiabilities”*, and requires that all separately recognized servicingassets and servicing liabilities be initially measured at fair value, ifpracticable, and permits the entities to elect either fair value measurementwith changes in fair value reflected in earnings or the amortization andimpairment requirements of SFAS No. 140 for subsequent measurement. Thesubsequent measurement of separately recognized servicing assets and servicingliabilities at fair value eliminates the necessity for entities that manage therisks inherent in servicing assets and servicing liabilities with derivativesto qualify for hedge accounting treatment and eliminates the characterizationof declines in fair value as impairments or direct write-downs. This Statementis effective as of the beginning of an entity’s first fiscal year that beginsafter September 15, 2006. The Company believes that this new accountingstandard has no impact on its financial condition or results of operations.

In September 2006, the SEC’s  Office of the Chief Accountant and Divisionsof Corporation Finance and Investment Management released SAB No. 108, *Considering the Effects of Prior Year Misstatementswhen*

8

----

*Quantifying Misstatements in Current Year FinancialStatements*(“SAB No. 108”). SAB No. 108 provides interpretive guidance on how the effects of thecarryover or reversal of prior year misstatements should be considered inquantifying a current year misstatement. The SEC staff believes thatregistrants should quantify errors using both a balance sheet and an incomestatement approach and evaluate whether either approach results in quantifyinga misstatement that, when all relevant quantitative and qualitative factors areconsidered, is material. This pronouncement is effective for fiscal yearsending after November 15, 2006. The Company believes the adoption of SAB No.108 has no material impact on its financial position, results of operations, orcash flows.

In September 2006, the FASB issued SFAS No. 157, *Fair Value Measurements*(“SFAS No. 157”).This statement provides a single definition of fair value, a framework formeasuring fair value, and expanded disclosures concerning fair value.Previously, different definitions of fair value were contained in variousaccounting pronouncements creating inconsistencies in measurement anddisclosures. SFAS No. 157 applies under those previously issued pronouncementsthat prescribe fair value as the relevant measure of value, except SFAS No.123(R) and related interpretations and pronouncements that require or permit measurementsimilar to fair value but are not intended to measure fair value. Thispronouncement is effective for fiscal years beginning after November 15, 2007.The Company is evaluating the impact of this new standard, but currentlybelieves that adoption will not have a material impact on its financialposition, results of operations, or cash flows.

In February 2007, the FASB issued SFAS No. 159, *The Fair Value Options for Financial Assets and Financial Liabilities —Including an amendment of FASB Statement No. 115*, which generallypermits the measurement of selected eligible financial instruments, includinginvestment securities, at fair value as of specified election dates and thereporting of unrealized gains or losses on those instruments in earnings at eachsubsequent reporting date. Generally, the fair value option may be applied onan instrument by instrument basis, but once applied, the election isirrevocable and is applied to the entire instrument. The statement is effectivefor fiscal years beginning after November 15, 2007, with early adoptionpermitted as of the beginning of the fiscal year that begins on or beforeNovember 15, 2007. The Company is evaluating the impact of this new standard,but currently believes that adoption will not have a material impact on itsfinancial position, results of operations, or cash flows.

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

**LoansReceivable**

Loans receivableare stated as unpaid principal balance net of any deferred fees and payments inprocess, less the allowance for loan losses.

Interest incomefrom loans receivable is recognized using the interest method whereby interestincome is recognized using the loan’s effective rate based upon outstandingprincipal. Loan origination fees received from borrowers are deferred andamortized into income over the established average life of related loan under amethod which approximates the effective interest rate method. Loan premiums anddiscounts are also amortized into interest income under the same method.

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

The Company incursdirect loan origination costs in its direct lending activities. These costs arecapitalized and amortized against interest income over the estimated averagelife of the loans under a method which approximates the effective interest ratemethod.

**ImpairedLoans**

Under the provisions of SFAS Nos. 114 and 118, *Accounting by Creditors for Impairment of a Loan*, a loan isconsidered impaired (or nonaccrual) if it is probable that the company will notcollect all principal and interest payments according to the loan’s contractedterms.  The impairment of the loan ismeasured at the present value of the expected cash flows using the loan’seffective interest rate, or the loan’s observable market price. Interest income

9

----

generally is not recognizedon 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’sprincipal balance. Interest income on the other nonaccrual loans is recognizedonly to the extent of interest payments received.

**Informationwith respect to impaired loans and the related allowance for loan losses isshown below:**
| ** **                                                                                  | ** ** | **March 31,  2007** | ** ** | **December 31,  2006** | ** ** |
|---------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                                                                                  | ** ** | **(unaudited)**          | ** ** | ** **                  | ** ** |
| Total recorded  investment in impaired loans                                                |       | $                        | 497,137    |                        | $          | 651,895 |   |
| Amount of that  recorded investment for which there is a related allowance for loan losses  |       | $                        | 497,137    |                        | $          | 631,289 |   |
| Amount of  related allowance for loan losses associated with such investment                |       | $                        | 188,353    |                        | $          | 285,316 |   |
| Amount of that recorded  investment for which there is no related allowance for loan losses |       | $                        | —     |                        | $          | 20,606 |   |

 
| ** **                                                                                     | ** ** | **For the three  months ended  March 31,  2007** | ** ** | **For the year ended  December 31,  2006** | ** ** |
|------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                                                                                     | ** ** | **(unaudited)**                                                      | ** ** | ** **                                                     | ** ** |
| Average recorded  investment in impaired loans during period                                   |       | $                                                                    | 574,516    |                                                           | $          | 744,142 |   |
| Related 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 |       | $                                                                    | —     |                                                           | $          | — |   |

 

As of March 31,2007 and December 31, 2006, the Company had loans of $1,634,947 and $1,748,342,respectively, which were more than ninety days past due and for which theCompany continues to accrue interest. The Company has adequate collateral for these loans and managementbelieves that both the principal and the related accrued interest arecollectible.

**Analysisof the allowance for loan losses is as follows:**
| ** **                 | ** ** | **For the three  months ended  March 31,  2007** | ** ** | **For the three  months ended  March 31,  2006** | ** ** |
|----------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                 | ** ** | **(unaudited)**                                                      | ** ** | **(unaudited)**                                                      | ** ** |
| Beginning  balance         |       | $                                                                    | 452,154    |                                                                 | $          | 369,791 |   |
| Provision for  loan losses |       | 45,000                                                               |       | 57,352                                                               |       |
| Loans charged  off         |       | (152,638                                                             | )          | —                                                               |       |
| Ending Balance             |       | $                                                                    | 344,516    |                                                                 | $          | 427,143 |   |

 

10

----

**NOTE D—INVESTMENTS**

Marketablesecurities consist of the following at the dates indicated:
| ** **                        | ** ** | **March 31, 2007** | ** ** |
|-----------------------------------|------------|------------------------------|------------|
| ** **                        | ** ** | **Amortized  Cost**          | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair   Value** | ** ** |
| Corporate bonds  (net of premium) |       | $                            | 617,699    |   | $ | — |   | $ | (23,693 | ) | $ | 594,006 |   |
|                                   |            |                              |            |  |  |  |  |  |  |  |  |  |  |

 
| ** **                        | ** ** | **December 31, 2006** | ** ** |
|-----------------------------------|------------|---------------------------------|------------|
| ** **                        | ** ** | **Amortized  Cost**             | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair   Value** | ** ** |
| Corporate bonds  (net of premium) |       | $                               | 615,317    |   | $ | — |   | $ | (34,168 | ) | $ | 581,149 |   |
|                                   |            |                                 |            |  |  |  |  |  |  |  |  |  |  |

 

In addition, other investments available for sale of$50,872 at March 31, 2007 and December 31, 2006 consist of an equity investmentin a private company.  The cost of thisnon-marketable security approximates the fair value of the investment.

**NOTE E—RELATED PARTY TRANSACTIONS**

Thefollowing related party transactions exist as of the dates shown below:

Included in notesreceivable at March 31, 2007 and December 31, 2006, are 13 notes totaling$9,382,580 and 14 notes totaling $9,571,428, respectively,  from officers, stockholders and a companycontrolled by an officer.  These notesall have annual maturities and are due in full on the maturity date unlessextended by the Company.  The interestrates on these notes range between 5.99% and 12.5%.

Included in the notespayable balance at March 31, 2007 and December 31, 2006, are 60 notes totaling$5,405,040 and 63 notes totaling $7,421,423, respectively, which are held byofficers and stockholders.  These noteswere all issued at the rate in effect for the applicable term selected as ofthe date the note was issued.

Included in the otherloans payable balance at March 31, 2007, are 7 loans totaling $6,758,072,borrowed from shareholders.

During the three monthsended March 31, 2007, we borrowed $16,627,002 from seven of our shareholdersand four high net worth individuals on a short-term basis. We repaid $9,237,935of the sums borrowed during the three months ended March 31, 2007 and theremaining $7,389,067 is included in other loans payable as of March 31,2007.  The majority of the borrowingswere with one shareholder who was owed $6,455,663 as of March 31, 2007. Thedebt is due and payable upon demand.

There is a notereceivable included in other receivables of $185,450, shown on the balancesheet at March 31, 2007 and December 31, 2006 as a contra-equity, made to theCompany’s CEO for the purchase of 100,000 shares of stock in the Company.  The interest rate on this loan is sevenpercent.  The stock has a book value ofabout $54,000 as of March 31, 2007.  AtMarch 31, 2007, there was no accrued interest receivable on this loan.

Included in the notesreceivable at March 31, 2007 are five loans in the amount of $8.56 million to atrust for the benefit of a significant shareholder. The majority of these loans($8.46 million) were made during the year ended December 31, 2006 and theremaining $0.1 million was made during the three months ended March 31, 2007.The proceeds of these loans were used to purchase real estate which serves assecurity for the loans. The loans bear interest at 8% per annum and have somevariable up-side features. Additional interest is earned on certain loans ifthe rental income the borrower receives from the property exceeds certainallowable expenses. In addition, upon the sale of certain real property(ies)(or components thereof), KH Funding is to receive one quarter or one-half,depending on the specific property, of any gain after adjusting for certaincosts and commissions. The loans do not have any variable down-side featureswhich would cause interest to be lower than the stated rate on each loan. Underthe terms of the loans any refinancing or sale of the properties must beapproved by KH Funding in advance.

11

----

All of the abovetransactions were consummated on substantially the same terms, includinginterest rates and collateral, as those prevailing for comparable transactionswith other customers.

**NOTE F—STOCK BASED COMPENSATION**

We have grantedstock-based compensation awards to employees and board members.  Awards may consist of common stock or stockoptions.  Our stock options have a fiveyear life.  These incentive stockoptions, vest over three years in three equal annual installments. The stockoptions we grant provide for option exercise prices equal to or greater thanthe fair market value of the common stock at the date of the grant.  Management determines the fair market valueof the common stock at that date.

No stock optionswere granted during either of the three months ended March 31, 2007 or2006.  We accrue related compensationexpenses as our options vest in accordance with SFAS123(R), *Share-Based Payment.* We recognized $7,500 and $0 compensation expense during the three monthsended March 31, 2007 and 2006, respectively, from the vesting of stock optionswe issued in earlier periods.  Totalstock based compensation expense was $7,500 and $9,975 for the three monthsended March 31, 2007 and 2006, respectively.

Asummary of stock option activity during the three months ended March 31, 2007and 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, 2007 |       | 471,250                     |       | $                                         | 2.40       |                                                                    |       |                                      | $          | 282,750 |   |
| Granted                         |       | —                      |       |                                      |       |                                                                    |       |                                      |       |
| Exercised                       |       | —                      |       |                                      |       |                                                                    |       |                                      |       |
| Forfeited                       |       | —                      |       |                                      |       |                                                                    |       |                                      |       |
|                            |       |                        |       |                                      |       |                                                                    |       |                                      |       |
| Outstanding at  March 31, 2007  |       | 471,250                     |       | $                                         | 2.40       |                                                                    | 4.29       |                                      | $          | 282,750 |   |
|                            |       |                        |       |                                      |       |                                                                    |       |                                      |       |
| Exercisable at  March 31, 2007  |       | 321,250                     |       | $                                         | 2.08       |                                                                    | 2.20       |                                      | $          | 295,550 |   |

 

Stock-basedcompensation also includes the value of stock granted to employees and boardmembers for services.  We recognizedstock-based compensation expense of  $0and $9,975 for stock grants for the three months ended March 31, 2007 and 2006,respectively.

**NOTE G—COMMITMENTS AND CONTINGENTLIABILITIES**

**Off-Balance Sheet Arrangements**

We enter into off-balancesheet arrangements in the normal course of our business. These arrangementsconsist primarily of our loans which are lines-of-credit or draw-type loans. AtMarch 31, 2007 we had $13.8 million in loans of this type. The unused orunfunded amount on these types of loans totaled $ 2.42 million as of March 31,2007.

 

12

----

**ITEM 2.**                    MANAGEMENT’SDISCUSSION AND ANALYSIS OR PLAN OF OPERATION

**Management’s Discussion andAnalysis or Plan of Operation and other sections of this Report contain “forward-lookingstatements,” as that term is defined in the Private Securities LitigationReform Act of 1995, that are based on management’s expectations, estimates,projections and assumptions.  Thesestatements may be identified by the use of forward-looking words or phrasessuch as “should”, “expects”, “anticipates”, “plans”, “believes”, “estimates”, “mightresult”, “projects” and variations of such words and similar expressions. Suchforward-looking statements are made pursuant to the safe harbor provisions ofthe Private Securities Litigation Reform Act of 1995.  These statements are not guarantees of futureperformance and involve certain risks and uncertainties that are difficult topredict.  Therefore, actual futureresults and trends may differ materially from what is indicated inforward-looking statements due to a variety of factors. Such risks anduncertainties include liquidity risks associated with our investor Notespayable on demand by the holders, other loans and short-term borrowings,delinquencies in our loan portfolio, capital levels, changes in market interestrates, inability to generate new loans, and competitive factors in ourmarketplace. Readers are cautioned not to place undue reliance on such forwardlooking statements, which speak only as of the date of this Report.  The Company assumes no obligation to updateany forward looking statements even if experience or future changes make itclear that projected results expressed or implied in such statements will notbe realized.**

**Overview**

We conduct our businessoperations from our headquarters in Silver Spring, Maryland. Its primarybusiness activities consist of originating, acquiring and servicing mortgageloans, and issuing interest-bearing debt securities to investors.  We refer to the debt securities that we issueas “investor Notes”. We purchase first and second trust residential loansnationwide from other lenders and banks. We also directly originate smallcommercial real estate mortgage loans and investment property residentialmortgage loans.

Our net income dependslargely upon our net interest income, which is the difference between interestincome from loans and investments, referred to as interest-earning assets, andinterest expense on investor Notes and other borrowed funds, referred to asinterest-bearing liabilities. Our net interest income may be affected by nationaland local economic conditions, policies established by regulatory authoritiesand competition.

In prior years weused funds obtained from loan repayments and offerings of our investor Notes tooriginate most of the loans in our portfolio. However, rather than directly originating new loans, in the last sixyears we have increasingly engaged in the wholesale purchase of loans for ourloan portfolio and are now purchasing approximately 80% of our new loans.  We will continue to expand this wholesale componentof our operations and expect it to continue to be a major part of our loanacquisition strategy.   This strategyenables us to expand our operations with a limited amount of additionalpersonnel and expense because we anticipate that only a minimal expansion ofour administrative functions will be needed to support an increased wholesalecomponent in our operations.  We plan toidentify and utilize additional brokers, lenders and banks as sources for ourloan acquisitions.

Historically, we have financedour operations through the sale of investor Notes to the public both directlyand through select, contracted NASD Broker-Dealers. Our distribution plan wassuccessful, establishing nearly 700 new investment accounts providing over $25million in funds. However, since the public offering for our investor Notesexpired in the second quarter of 2006, our growth has slowed significantly. Weexpect to resume our public offering of investor Notes in selected states bythe end of June 2007. We will seek successful, controlled growth going forward.

Recently, the sub-primemortgage banking environment has been experiencing considerable strain fromrising delinquencies and liquidity pressures. Several high profile sub-primemortgage lenders have failed. The increased scrutiny of the sub-prime lendingmarket is one of the factors that have impacted general market conditions, aswell as several significant sub-prime mortgage originators. Although we engageas part of our business in sub-prime lending, we believe that our exposure toproblems in the industry is limited as a result of several factors. First, webelieve that we are underwriting our sub-prime mortgage loans to a higherstandard than the failing and delinquent loans from the more aggressive lendersin the mortgage industry. Second, we do not offer

13

----

the loan products that are receiving the harshestcriticism from regulators, commentators and Congress. Notably, as a generalmatter, the sub-prime loans that we originate or purchase have loan to valueratios that are less than 70%, as opposed to ratios of 95% or higher allowed bymany sub-prime lenders. In addition, we do not offer so-called “teaser” rateadjustable loans, low or no document or “stated income” loans. Third, our sizedoes not require us to generate or purchase high volumes of sub-prime mortgageloans so we can look much more closely at the individual borrowers, as in thecase of loans that we originate. In the case of purchased loans, we rely onstrict purchase criteria relating to LTV ratios and documentation. Of course,if there is a major downturn in real estate values, our procedures andpractices may not be adequate to prevent or materially diminish an adverseaffect on our financial condition or results of operations.

**CriticalAccounting Policies**

Our significantaccounting policies are disclosed in the footnotes to the financial statementsincluded in the Company’s Form 10-KSB for the year ended December 31,2006.  Management believes the followingsignificant accounting policies also are considered critical accountingpolicies:

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

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

**Comparison ofFinancial Condition at March 31, 2007 and December 31, 2006**

*Assets*.  Total assets decreased by $697,689, from$63,325,701 at December 31, 2006 to $62,628,012 at March 31, 2007.  The size of our loan portfolio increased$1570,446 ending at $56,274,466.  Cashdecreased $2,197,599, from $3,823,013 at December 31, 2006 to $1,625,414 atMarch 31, 2007.  The decrease in totalassets is primarily a result of the expiration of our offering of investorNotes in the second quarter of 2006.  See“Liquidity and Capital Resources”

*Liabilities*.  Total liabilities decreased by $745,490, from$61,907,387 at December 31, 2006 to $61,161,897 at March 31, 2007.  The net decrease was primarily due to adecrease of $8,475,050 in investor Notes and an increase of $7,714,067 in otherloans payable.

*Equity*.  Total stockholders’ equity increased by$47,801 from $1,418,314 at December 31, 2006 to $1,466,115 at March 31,2007.  The increase was due to net incomeof $84,364, plus stock-based compensation of $7,500 and an increase of $10,475in the fair value of marketable investment securities, less cash dividenddistributions of $54,538 during the three month period.

*Past DueLoans*.  We generallypurchase or make “hard collateral” loans, based largely on collateral value andin which the loan amount is below 70% of the collateral value. As of March 31,2007 we held six loans that were more than 90 days past due but are stillaccruing interest.  The total principaland interest due on these loans was $1,634,946. Five of the loans, totaling $1,589,684, are first trust real estateloans on which we do not expect to suffer any loss due to collateral value, andwe anticipate that the other loan of $45,262 will become current in the

14

----

near future.  We continue to accrue interest on these loansbased on the underlying collateral value and payment history.  We monitor these loans on a continual basis.

*Non-AccrualLoans*.  As of March 31,2007, there were 12 loans in non-accrual status with an outstanding principalbalance totaling $497,137.  The majorityof these loans are first trust loans that are well collateralized.  In the event we have to foreclose on any ofthese loans, we do not expect any significant loss in excess of amountsreserved.  We have a specific reserve of$188,353 and a general reserve of $142,575 as part of our total reserve of$344,516 for anticipated and unanticipated loan losses.

**Comparison ofOperating Results for Three Months Ended March 31, 2007 and 2006**

*Netinterest margin.* The average yield earned on loans receivablewas 10.45% for the three months ended March 31, 2007 and 10.54% for the threemonths ended March 31, 2006.  The averagerate paid on investor Notes increased to 6.79% for the three months ended March31, 2007 from 6.10% for the three months ended March 31, 2006, due primarily toan increase in the contractual rates we are required to pay on investor Notes.Overall, the net margin on interest decreased to 3.66% for the three monthsended March 31, 2007, from 4.44% for the three months ended March 31,2006.  This net margin is calculated usingcontractual rates and excludes fee income and expense.

*NetIncome*.  Net income forthe three months ended March 31, 2007 was $84,364 compared to net income of$95,134 for the three months ended March 31, 2006.

*InterestIncome*.  Total interestincome was $1,532,545 for the three months ended March 31, 2007, compared to$1,310,995 for the same period in 2006. The additional income resulted primarily from growth in the averageamount of interest-earning assets between the two periods, mostly from an increasein loans receivable.  The interest incomeincludes point and fee income and interest earned on bank investments andmarketable securities.

*InterestExpense*.  Interestexpense was $1,084,317 for the three months ended March 31, 2007, and $851,979for the corresponding period in 2006. The additional expense resulted primarily from an increase in theinterest rates paid on investor Notes outstanding.  The interest expense includes theamortization of fees paid to Brokers-Dealers in prior periods for the sale ofinvestor Notes.

*Provisionfor Loan Losses*.  Ourprovision for loan losses was $45,000 for the three months ended March 31,2007, compared to $57,352 for the three months ended March 31, 2006.  These provisions increased the allowance forloan losses to an amount deemed by management to be sufficient to meet allanticipated loan losses plus a general amount to meet unforeseen loanlosses.  The adequacy of the allowance isperiodically reviewed and adjusted by management based upon past experience,the value of the underlying collateral for specific loans, known or inherentrisks in the loan portfolio and current economic conditions.

*Non-InterestIncome*.  We hadnon-interest income of $17,073 during the three months ended March 31, 2007compared to $15,660 for the corresponding period in 2006.  The difference was due to an increase in therental income from other real estate owned.

*Non-InterestExpense*.  Weexperienced an increase in non-interest expense to $335,938 for the threemonths ended March 31, 2007 from $322,190 for the three months ended March 31,2006.  Increases in salaries and wagesand real estate maintenance costs were only partially offset by decreases inoffering costs and various administration costs.

*IncomeTaxes*.  KH FundingCompany has elected to be treated as a Subchapter S corporation under theInternal Revenue code and accordingly no income tax expense appears in thefinancial statements.

**Liquidity andCapital Resources**

For the three monthsended March 31, 2007, net cash provided by operating activities was $654,481.Cash provided by operating activities for the three months ended March 31,2007 was from net income, depreciation, compensation, and other non-cashcharges, and an increase in interest payable, totaling $868,006, offset by anincrease in interest receivable, amortization and prepayments of $213,525.

For the three monthsended March 31, 2007, net cash used in investing activities was $1,330,971. Theexpenditures included $4,469,384 for loans made to borrowers and $9,926 ofother purchases and payments. These expenditures were partially offset byprincipal repayments from of $2,571,917 and payments of other receivables of$576,422 during the three months ended March 31, 2007.

For the three monthsended March 31, 2007, net cash used by financing activities was$1,521,109.  Proceeds from other loanspayable of $16,952,001 and investor Notes of $898,276, together with anincrease in unapplied deposits of $30,250 were offset by principal payments oninvestor Notes of $10,081,768, payments on other loans payable of $9,237,935,dividend distributions of $54,538, and a decrease in escrow and securitydeposits of $27,395.

During the three monthsended March 31, 2007, the proceeds from investor Notes of $898,276 resultedprimarily from pre-authorized and direct deposits that were not anticipated. Intotal, principal payments of investor Notes of $1,737,039 have been refunded tothe investors affected by these inadvertent transactions.

Historically KH FundingCompany’s primary sources of funding have been the proceeds from the sale ofinvestor Notes, principal and interest payments received from loans receivable,proceeds from the sale of loans and rental income from real estate owned andheld for rental. While maturities and scheduled amortization of loans receivableand investments are predictable sources of funds, the sale and redemption ofinvestor Notes and mortgage loan prepayments are greatly influenced by interestrate trends, economic conditions and competition. Our one-day

15

----

and thirty daydemand investor Notes can cause significant volatility in our cash balances. Wecontend with this volatility through our liquidity strategy which is discussedbelow.

The table belowillustrates the sales of investor Notes versus redemptions for the yearsindicated:
| **Year** | ** ** | **Notes Sold** | ** **  | **Notes Redeemed** | ** ** | **Percentage** | ** ** |
|----------|------------|---------------------|-------------|-------------------------|------------|----------------|------------|
| 2002     |       | $                   | 22,926,619  |                    | $          | 18,681,654     |       | 81.48% |   |
| 2003     |       | $                   | 26,630,166  |                    | $          | 24,697,770     |       | 92.74% |   |
| 2004     |       | $                   | 49,008,102  |                    | $          | 44,786,895     |       | 91.39% |   |
| 2005     |       | $                   | 120,110,831 |                    | $          | 96,630,099     |       | 80.45% |   |
| 2006     |       | $                   | 106,101,789 |                    | $          | 95,933,794     |       | 90.42% |   |

** **

One of our primaryliquidity needs is the funding of redemption requests on our one-day demand andthirty-day demand exists if the requests for redemption exceed the amount ofreadily available cash, i.e., if our liquidity is insufficient to fundredemptions. Upon the sale of an investor Note, the funds for redemption areimmediately available.  Part of our investmentstrategy is to place funds that are invested with us for a longer period intohigher yielding, less liquid investments, such as mortgages; nevertheless, thefunds are still available, just not immediately.  Only holders of one-day demand Notes can makeredemption requests on less than thirty days notice, and we make an effort tokeep funds available for these requests. Only holders of thirty-day demand Notes can make redemption requests onless than 90 days notice, and if the funds will not be available within thirtydays, we will sell some of our loans receivable to have the funds available tomeet requests for funds from these Note holders. All other types of Notes, thatis the term notes of one, three and five years, are redeemable upon maturity,or prior to maturity on 90 days advance notice, subject to a penalty. Ifnecessary, we will sell loans from our portfolio in bulk to fund redemptionrequests from our Note holders.

The Company strives tomaintain sufficient liquidity to meet all redemption requests.  We normally hold 3% to 7% of our assets incash and cash equivalents to fund redemptions of one-day demand Notes.  This amount has historically been sufficientfor us to meet our redemption obligations. Also, if required, we are able tosell loans within 30 days to raise cash to meet redemption requests from 30-daydemand Note holders or within 90 days to meet early redemption requests fromterm Note holders.

As noted above, ourpublic offering of investor Notes expired in the second quarter of 2006,pending the filing of a new Registration Statement.  We currently expect to resume our publicoffering of investment Notes in selected states by late June 2007 by filing anupdate to our Registration Statement with the Securities and Exchange Commissionand applicable state securities regulators.

**Redemption ofNotes.**As disclosed in our Annual Report on Form 10-KSBfor the year ended December 31, 2006, we recently exercised our right to make amandatory call of Notes from certain holders of investor Notes that areresidents of states in which our offering was not then registered or otherwisemay not have been qualified under those states’ blue sky laws. Accordingly, weredeemed a total of $1.47 million in principal and interest amounts of investorNotes during late December 2006 and early January 2007. Subsequent to March 31,2007, a small number of accredited investors, most of whom are affiliates ofthe Company or pre-existing Note holders, elected to retain their investorNotes of approximately $3.1 million in aggregate principal amount, and theCompany redeemed approximately $450,000 in principal amount of investor Notesheld by other investors.

*Plan toRaise Additional Capital. *Weintend to continue to expand our operations through future public offerings ofinvestor Notes by the Company and select, contracted broker-dealers.  Our goal is to maintain a capital level of atleast 3%-5% of total assets through the private sale of stock fromtime-to-time.  However, there is noassurance that such transactions will occur or be successful. As of March 31,2007, our stockholders’ equity was $1.47 million or approximately 2.3% of ourtotal assets of $62.63 million.

16

----

**Known Trends,Events of Uncertainties**

*Impact ofInflation and Interest Rates*. The financial statements of the Company and notes thereto, presentedelsewhere herein, have been prepared in accordance with accounting principlesgenerally accepted in the United States of America, which require themeasurement of financial position and operating results in terms of historicaldollars without considering the change in the relative purchasing power ofmoney over time and due to inflation. The impact of inflation is generally to increase the value of underlyingcollateral for the loans made by the Company to its borrowers. Unlike typicalindustrial companies, nearly all the assets and liabilities of the Company aremonetary in nature. As a result, interest rates have a greater impact on ourperformance than the effects of inflation generally.

*Stockholders’Equity*.  Totalstockholders’ equity has decreased as a percentage of total assets over thelast six years, from 10.6% at December 31, 1999 to 2.3% at March 31, 2007.  During this time period total stockholders’equity in dollars has remained fairly constant while total assets in dollarshave increased, causing the equity-to-assets ratio to decrease. Although theratio has decreased compared to what it has been in the past, managementbelieves that the present ratio remains adequate. In future periods the Companyexpects dividend distributions to stockholders to be less than the net incomein order to inhibit further decreases in stockholders’ equity.

**ITEM 3.**                    CONTROLS ANDPROCEDURES

As of the end of theperiod covered by this Form 10-QSB, our management, with the participation ofour Chief Executive Officer and our Chief Financial Officer, carried out anevaluation of the effectiveness of the design and operation of our disclosurecontrols and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under theSecurities Exchange Act of 1934).  Basedupon that evaluation, our Chief Executive Officer and our Chief FinancialOfficer concluded that our disclosure controls and procedures are effective asof the end of the period covered by this report.

There were no changes inthe Company’s internal control over financial reporting during the three monthsended March 31, 2007 that have materially affected, or are reasonably likely tomaterially affect, our internal control over financial reporting.

**PART II—OTHER INFORMATION**

**ITEM 1.**                    LEGAL PROCEEDINGS

On March 8, 2005 we werenotified that a lawsuit had been filed against us (In Circuit Court ofMontgomery County, Maryland) by a company known as SBM Financial, LLC (“SBM”).SBM claims to operate a business similar to ours. SBM claims that we haveintentionally interfered with the ability of SBM to retain their existinginvestors.  Recently, the SEC requestedthat a receiver be appointed to liquidate the assets of SBM. We believe thatthe SBM’s lawsuit is groundless.  Atpresent, we expect no material impact on KH Funding as a result of thislitigation.

**ITEM2.**                    UNREGISTEREDSALES OF SECURITIES AND USE OF PROCEEDS

Not applicable.

**ITEM3.**                    DEFAULTSUPON SENIOR SECURITIES

Not applicable.

**ITEM4.**                    SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

Not applicable.

**ITEM5.**                    OTHERINFORMATION

Not applicable.

17

----

**ITEM 6.**                    EXHIBITS AND REPORT ON FORM 8-K

(a)           Exhibits

Exhibit 31.1 —           Certificationby the Chief Executive Officer Pursuant to Section 302 of the Sarbanes-OxleyAct of 2002

Exhibit 31.2 —           Certificationby the Chief Financial Officer Pursuant to Section 302 of the Sarbanes-OxleyAct of 2002

Exhibit 32.1 —           Certificationby the Chief Executive Officer Pursuant to 18 U.S.C. Section 1350 AdoptedPursuant to Section 906 of the Sarbanes-Oxley Act of 2002

Exhibit 32.2—              Certificationby the Chief Financial Officer Pursuant to 18 U.S.C. Section 1350 AdoptedPursuant to Section 906 of the Sarbanes-Oxley Act of 2002

(b)           Reports on Form 8-K

None.

18

----

**SIGNATURE**

In accordance with therequirements of the Securities Exchange Act of 1934, the Registrant caused thisreport to be signed on its behalf by the undersigned, thereunto dulyauthorized.
|                      |   | KH FUNDING COMPANY      |
|----------------------|--------|-------------------------|
|                 |   | (Registrant)            |
|                 |   |                    |
|                 |   |                    |
| Dated: May 22,  2007 |   | /s/ William M. Baker    |
|                 |   | William M. Baker        |
|                 |   | Chief Financial Officer |

 

(Mr. Baker is the Principal Financial and AccountingOfficer and has been duly authorized to sign on behalf of the Registrant.)

19

----