Table of Contents





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 March
31, 2009





OR





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





For the
transition period from ________ to ________





Commission
file number 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
 ̈





Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files).  Yes o   No o  (Not
Applicable)





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 filer  ̈
            Accelerated
      filer  ̈Non-accelerated
      filer  ̈
            Smaller
      reporting company x(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  ̈   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:  3,074,981 shares, par value
$.01 per share, of common stock outstanding as of March 31, 2009.









Table of Contents




INDEX




PagePart I.  Financial Information
            3Item 1.  Financial Statements
            3Balance Sheets - March 31, 2009 (unaudited) and December 31,
      2008
            3Statements of Operations (unaudited) - For the three months
      ended March 31, 2009 and 2008
            4Statements of Changes in Stockholders’ (Deficit) Equity
      (unaudited) - For the three months ended March 31, 2009 and
      2008
            5Statements of Cash Flows (unaudited) - For the three months
      ended March 31, 2009 and 2008
            6Notes to Interim Financial Statements
      (unaudited)
            7Item 2.  Management’s Discussion and Analysis of
      Financial Condition and Results of Operations
            14Item 4.  Controls and
    Procedures
            19Part II.  Other Information
            19Item 1.  Legal Proceedings
            19Item 1A.  Risk Factors
            20Item 3.  Defaults Upon Senior
      Securities
            20Item 6.  Exhibits
            20Signatures
            21Exhibit Index
            22






- 2
-
 Table of Contents




PART I – FINANCIAL INFORMATION





Item 1.  Financial Statements.





KH
FUNDING COMPANY


BALANCE SHEETS




March
      31,
              2009
            
            
            December
      31,
              2008(unaudited)AssetsCash
            
            $
            49,900
            
            
            $
            221,463Loans,
      less allowance for loan losses of $632,659(March
      31,2009) and $659,242 (December 31, 2008)
            
            
            36,895,311
            
            
            
            36,860,118Accrued
      interest receivable
            
            
            1,735,333
            
            
            
            2,155,100Other
      receivables
            
            
            452,429
            
            
            
            542,718Prepaid
      expenses
            
            
            215,559
            
            
            
            219,458Property
      and equipment – Net
            
            
            72,128
            
            
            
            101,070Real
      estate owned:Rental
      property
            
            
            2,069,422
            
            
            
            2,079,374Held
      for sale
            
            
            3,983,069
            
            
            
            2,652,069Other
      assets
            
            
            15,988
            
            
            
            15,988Total
      Assets
            
            $
            45,489,139
            
            
            $
            44,847,358Liabilities
      and Stockholders’ DeficitLiabilitiesNotes
      and accrued interest payable
            
            $
            38,463,931
            
            
            $
            38,828,923Other
      loans payable
            
            
            —
            
            
            
            92,408Accounts
      payable and accrued expenses
            
            
            103,020
            
            
            
            42,705Escrows
      and security deposits
            
            
            88,152
            
            
            
            81,115Long-term
      liabilities
            
            
            50,407
            
            
            
            50,857Loans
      sold with recourse
            
            
            4,436,862
            
            
            
            4,454,698Collateralized
      notes payable
            
            
            2,572,742
            
            
            
            1,678,782Total
      Liabilities
            
            
            45,715,114
            
            
            
            45,229,488Stockholders’
      DeficitCommon
      stock (5,000,000 shares authorized; 3,074,981 shares  (March 31,
      2009) and 2,574,981 shares (December 31, 2008) issued and outstanding,
      $0.01 par value)
            
            
            30,750
            
            
            
            25,750Paid-in
      capital
            
            
            1,948,006
            
            
            
            1,448,738Accumulated
      deficit
            
            
            (2,019,281
            )
            
            
            (1,671,168
            )Stock
      subscription note receivable
            
            
            (185,450
            )
            
            
            (185,450
            )Total
      Stockholders’ Deficit
            
            
            (225,975
            )
            
            
            (382,130
            )Total
      Liabilities and Stockholders’ Deficit
            
            $
            45,489,139
            
            
            $
            44,847,358






The
accompanying notes are an integral part of these statements.




- 3
-
 Table of Contents




KH
FUNDING COMPANY


STATEMENTS OF OPERATIONS (UNAUDITED)


For
      the ThreeMonths
              Ended
      March 31,2009
            
            
            2008Interest
      IncomeInterest
      and fees on loans
            
            $
            811,668
            
            
            $
            1,214,137Interest
      on bank accounts
            
            
            201
            
            
            
            45Total
      interest income
            
            
            811,869
            
            
            
            1,214,182Interest
      ExpenseInterest
      and fees on notes
            
            
            597,095
            
            
            
            869,777Interest
      on other loans
            
            
            11,431
            
            
            
            91,635Interest
      on collateralized notes payable andloans
      sold with recourse
            
            
            125,710
            
            
            
            8,068Total
      interest expense
            
            
            734,236
            
            
            
            969,480Net
      interest income
            
            
            77,633
            
            
            
            244,702Provision
      for Loan Losses
            
            
            33,728
            
            
            
            79,098Net
      Interest Income after Provision for Loan Losses
            
            
            43,905
            
            
            
            165,604Non-interest
      IncomeRental
      income
            
            
            32,202
            
            
            
            22,430Loss
      on sale of fixed assets
            
            
            (10,906
            )
            
            
            —Other
            
            
            880
            
            
            
            7,239Total
      non-interest income
            
            
            22,176
            
            
            
            29,669Non-interest
      ExpenseSalaries
      and wages
            
            
            78,081
            
            
            
            86,877Professional
      fees
            
            
            148,606
            
            
            
            49,959Offering
      costs
            
            
            48,322
            
            
            
            32,780Administration
            
            
            12,156
            
            
            
            16,703Real
      estate maintenance
            
            
            42,298
            
            
            
            21,172Insurance
            
            
            13,044
            
            
            
            17,108Depreciation
            
            
            17,987
            
            
            
            15,627Rent
            
            
            31,204
            
            
            
            29,819Bank
      charges
            
            
            12,972
            
            
            
            13,755Stock
      based compensation
            
            
            4,268
            
            
            
            3,523Other
            
            
            5,256
            
            
            
            2,873Total
      non-interest expense
            
            
            414,194
            
            
            
            290,196Net
      Loss
            
            $
            (348,113
            )
            
            $
            (94,923
            )Basic
      loss per share
            
            $
            (0.12
            )
            
            $
            (0.04
            )Diluted
      loss per share
            
            $
            (0.12
            )
            
            $
            (0.04
            )Cash
      dividends paid per common share
            
            
            —
            
            
            
            —






The
accompanying notes are an integral part of these statements.




- 4
-
 Table of Contents




KH
FUNDING COMPANY


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


FOR
THE THREE MONTHS ENDED MARCH 31, 2009 and 2008




Common
      Stock
            
            
            Paid-In
            
            
            Accumulated
            
            
            Subscription
      Note
            
            
            Total
      Stockholders’Shares
            
            
            Amount
            
            
            Capital
            
            
            Deficit
            
            
            Receivable
            
            
            Equity
      (Deficit)Balances
      at January 1, 2008
            
            
            2,724,981
            
            
            $
            27,250
            
            
            $
            1,730,911
            
            
            $
            (533,645
            )
            
            $
            (185,450
            )
            
            $
            1,039,066Stock
      Redemptions
            
            
            (150,000
            )
            
            
            (1,500
            )
            
            
            (298,500
            )
            
            
            —
            
            
            
            —
            
            
            
            (300,000
            )Stock
      Based Compensation Expense
            
            
            —
            
            
            
            —
            
            
            
            3,523
            
            
            
            —
            
            
            
            —
            
            
            
            3,523Net
      loss for period ended March 31, 2008
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            (94,923
            )
            
            
            —
            
            
            
            (94,923
            )Balances
      at March 31, 2008
            
            
            2,574,981
            
            
            $
            25,750
            
            
            $
            1,435,934
            
            
            $
            (628,568
            )
            
            $
            (185,450
            )
            
            $
            647,666Balances
      at January 1, 2009
            
            
            2,574,981
            
            
            $
            25,750
            
            
            $
            1,448,738
            
            
            $
            (1,671,168
            )
            
            $
            (185,450
            )
            
            $
            (382,130
            )Stock
      Issued
            
            
            500,000
            
            
            
            5,000
            
            
            
            495,000
            
            
            
            —
            
            
            
            —
            
            
            
            500,000Stock
      Based Compensation Expense
            
            
            —
            
            
            
            —
            
            
            
            4,268
            
            
            
            —
            
            
            
            —
            
            
            
            4,268Net
      loss for period ended March 31, 2009
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            (348,113
            )
            
            
            —
            
            
            
            (348,113
            )Balances
      at March 31, 2009
            
            
            3,074,981
            
            
            $
            30,750
            
            
            $
            1,948,006
            
            
            $
            (2,019,281
            )
            
            $
            (185,450
            )
            
            $
            (225,975
            )






The
accompanying notes are an integral part of these statements.


- 5
-
 Table of Contents




KH
FUNDING COMPANY


STATEMENTS OF CASH FLOWS (UNAUDITED)





For
      the three months
              ended
      March 31,2009
            
            
            
            2008Cash
      from Operating ActivitiesNet
      loss
            
            $
            (348,113
            )
            
            $
            (94,923
            )Adjustments
      to Reconcile Net Income to Net Cash from Operating
    Activities:Depreciation
            
            
            17,987
            
            
            
            15,630Amortization
      of loan fees
            
            
            (7,500
            )
            
            
            (7,500
            )Provision
      for loan losses
            
            
            33,728
            
            
            
            79,098Loss
      on sale of fixed asset
            
            
            10,907
            
            
            
            —Stock
      based compensation expense
            
            
            4,268
            
            
            
            3,524Changes
      in Operating Assets and LiabilitiesAccrued
      late charges
            
            
            (32,428
            )
            
            
            (6,677
            )Prepaid
      expenses
            
            
            (10,483
            )
            
            
            32,554Accrued
      interest receivable
            
            
            (174,783
            )
            
            
            1,019,969Interest
      payable (included in notes payable)
            
            
            335,986
            
            
            
            563,072Accounts
      payable and accrued expenses
            
            
            60,315
            
            
            
            435Prepaid
      offering costs
            
            
            14,382
            
            
            
            18,045Deferred
      loan origination costs
            
            
            3,000
            
            
            
            3,450Unamortized
      brokerage fees
            
            
            (9,900
            )
            
            
            15,500Long
      term lease liability
            
            
            (450
            )
            
            
            4,050Prepaid
      loan expenses
            
            
            25,500
            
            
            
            25,797Net
      Cash (Used in) Provided by Operating Activities
            
            
            (77,584
            )
            
            
            1,672,024Cash
      Flows from Investing ActivitiesPrincipal
      repayments from borrowers
            
            
            531,461
            
            
            
            5,841,137Loans
      made to borrowers
            
            
            (270,868
            )
            
            
            (4,265,201
            )Net
      other receivables
            
            
            (154,953
            )
            
            
            (93,102
            )Proceeds
      from sale of fixed assets
            
            
            10,000Net
      Cash Provided by Investing Activities
            
            
            115,640
            
            
            
            1,482,834Cash
      Flows from Financing ActivitiesProceeds
      from payable notes
            
            
            1,122,803
            
            
            
            851,270Principal
      payments on payable notes
            
            
            (2,417,148
            )
            
            
            (7,853,052
            )Proceeds
      from loans sold with recourse
            
            
            —
            
            
            
            3,996,875Principal
      payments on loans sold with recourse
            
            
            (17,836
            )Proceeds
      from collateralized notes payable
            
            
            1,103,636Other
      loans payable
            
            
            —
            
            
            
            155,094Redemption
      of common stock
            
            
            
            
            
            
            (300,000
            )Decrease
      in escrow and security deposits
            
            
            (1,074
            )
            
            
            (12,276
            )Net
      Cash Used in Financing Activities
            
            
            (209,619
            )
            
            
            (3,162,089
            )Net
      (Decrease) in Cash
            
            
            (171,563
            )
            
            
            (7,231
            )Cash Balance, beginning
      of period
            
            
            221,463
            
            
            
            95,622Cash Balance,end of
      period
            
            $
            49,900
            
            
            $
            88,391Supplemental
      Cash Flow Information:Interest
      paid
            
            $
            368,512
            
            
            $
            406,401Transfer
      of loans to real estate owned
            
            $
            1,331,000
            
            
            $
            541,976






The
accompanying notes are an integral part of these statements.




- 6
-
 Table of Contents




KH
Funding Company


Notes to Interim Financial Statements


For the
Three Months Ended March 31, 2009 and 2008


(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 March 31, 2009 and the results of
operations, changes in stockholders’ (deficit) equity, and cash flows for the
three-month periods ended March 31, 2009 and 2008 have been
included.  All such adjustments are of a normal recurring
nature.  The amounts as of December 31, 2008 were derived from audited
financial statements.  The results of operations for the three-month
period ended March 31, 2009 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-K for the year ended December 31, 2008.





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-K for the year ended December 31, 2008, 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 Series 3 secured notes and
Series 4 unsecured notes, was declared effective by the Securities and Exchange
Commission (the “SEC”) and by the Maryland Division of Securities on November
10, 2008 but expired on April 30, 2009.  Accordingly, the Company
enjoyed only a limited period during the last 3 years during which it was able
to sell its investor notes and raise much needed funds for
operations.  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 continue to receive unscheduled and scheduled loan payments on a
going-forward basis, it is doubtful that these funds, alone, can meet the
Company’s cash needs.  The Company intends to file an amendment to its
expired registration statement to add updated financial information so that it
may recommence selling its investor notes, but this amended registration must be
declared effective by the SEC and applicable state securities regulators before
sales can begin.  There can be no assurance as to when the amended
registration statement will be filed or when it will be declared
effective.  Additionally, stockholders’ deficit at March 31, 2009 has
decreased to (0.50%) 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
when it will again be able to sell its investor notes, 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-K for the year
ended December 31, 2008 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
-
 Table of Contents




Loss
Per Share





Basic loss per share is computed by
dividing net losses incurred by the Company by the weighted-average number of
common shares outstanding.  Diluted loss per share is computed after
adjusting the denominator of the basic loss per share computation for the
effects of all dilutive potential common shares outstanding during the
period.  As of March 31, 2009 and March 31, 2008, the Company had
outstanding stock options to purchase 241,250 and 241,250 shares of common
stock, respectively. For the three months ended March 31, 2009 and 2008, options
to purchase 80,000, and 150,000 shares, respectively, were excluded from the
computation of diluted loss per share as their effect would have been
anti-dilutive.





For
      The ThreeMonths
              EndedMarch
      31,2009
            
            
            2008(unaudited)Basic:Net
      loss (attributable to common stock)
            
            $
            (348,113
            )
            
            $
            (94,923
            )Weighted
      average common shares outstanding
            
            
            2,952,759
            
            
            
            2,576,648Basic
      loss per share
            
            $
            (0.12
            )
            
            $
            (0.04
            )Diluted:Net
      loss (attributable to common stock)
            
            $
            (348,113
            )
            
            $
            (94,923
            )Weighted
      average common shares outstanding
            
            
            2,952,759
            
            
            
            2,576,648Dilutive
      effect of stock options
            
            
            —Weighted
      average common shares outstanding-diluted
            
            
            2,952,759
            
            
            
            2,576,648Diluted
      loss per share
            
            $
            (0.12
            )
            
            $
            (0.04
            )




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.




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.






- 8
-
 Table of Contents





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
-
 Table of Contents




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:





March
      31,
              2009
            
            
            December
      31,
              2008(unaudited)Total
      recorded investment in impaired loans
            
            $
            4,207,067
            
            
            $
            4,043,791Amount
      of that recorded investment for which there is a related allowance for
      loan losses
            
            $
            1,263,315
            
            
            $
            1,691,398Amount
      of related allowance for loan losses associated with such
      investment
            
            $
            385,059
            
            
            $
            448,298Amount
      of that recorded investment for which there is no related allowance for
      loan losses
            
            $
            2,943,752
            
            
            $
            2,352,393





For
      the three months
              ended
      March 31,
              2009
            
            
            For
      the year ended
              December
      31,
              2008(unaudited)Average
      recorded investment in impaired loans during period
            
            $
            4,125,429
            
            
            $
            2,949,641Related
      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 March 31, 2009 and December 31,
2008, the Company had loans of $6,675,110 and $10,006,949, 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 three months
              ended
      March 31,
              2009
            
            
            For
      the three months
              ended
      March 31,
              2008(unaudited)
            
            
            (unaudited)Beginning
      balance
            
            $
            659,297
            
            
            $
            495,480Provision
      for loan losses
            
            
            33,728
            
            
            
            79,098Loans
      charged off
            
            
            (60,366
            )
            
            
            (49,380
            )Ending
      Balance
            
            $
            632,659
            
            
            $
            525,198




NOTE
D - RELATED PARTY TRANSACTIONS





Included in notes receivable at March
31, 2009 and December 31, 2008, are 12 notes totaling $11,013,092 and
$10,788,498, respectively, from officers, significant stockholders and entities
controlled by a significant 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 (94.6%) of these notes receivable were due from one
stockholder and its related interests, who owed $10,419,712 as of March 31,
2009.




- 10
-
 Table of Contents




Included
in the notes receivable at March 31, 2009 and December 31, 2008 are six loans in
the amount of $10,42 million and 10.19 million, respectively, to a trust for the
benefit of a significant stockholder.  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 for March 31, 2009 and December 31, 2008,
respectively.  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.





Included in the notes payable and other
loans payable balances at March 31, 2009 and December 31, 2008, are 54 notes
totaling $6,760,852 and 56 notes totaling $7,163,483, 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.





There is an interest-only demand note
receivable of $185,450 included in other receivables, shown on the balance sheet
at March 31, 2009 and December 31, 2008 as a contra-equity, made to the
Company’s CEO for the purchase of 100,000 shares of stock in the Company, which
secure the loan.  The interest rate on this loan is
7.00%.  At March 31, 2009 and December 31, 2008, all payments under
this loan had been timely made and there was no accrued interest receivable on
this loan.





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 three months ended March 31,
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
E - 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 three months ended March 31, 2009 or 2008.  The Company accrues
related compensation expenses as its options vest in accordance with SFAS
123(R), Share-Based
Payment.  The Company recognized $4,268 and $3,524 stock-based
compensation expense during the three months ended March 31, 2009 and 2008,
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 for the three months ended March
31, 2009 and 2008.





A summary of stock option activity
during the three months ended March 31, 2009 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
      ValueOutstanding
      at January 1, 2009
            
            
            241,250
            
            
            $
            2.39
            
            
            
            
            
            $
            —Granted
            
            
            —Exercised
            
            
            —Forfeited
      or expired
            
            
            —
            
            
            
            
            
            
            
            
            
            
            —Outstanding
      at March 31, 2009
            
            
            241,250
            
            
            
            2.39
            
            
            
            1.08
            
            
            
            —Exercisable
      at March 31, 2009
            
            
            214,584
            
            
            
            2.29
            
            
            
            0.94
            
            
            
            —






- 11
-
 Table of Contents




Warrants





In
January 2009 the Company issued warrants to purchase 250,000 shares of common
stock with an exercise price of $1.00 per share.  These warrants were
issued in connection with the private placement of 500,000 shares of common
stock at $1.00 per share in January 2009.  In this private placement,
one warrant was issued for each two shares of common stock sold.  The
warrants expire in January 2014.  These warrants represent the only
warrants outstanding at March 31, 2009 and their issuance the only warrant
activity for the three months then ended.  There were no warrants
outstanding at March 31, 2008, nor was there any warrant activity for the three
months then ended.





NOTE
F - 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 March 31, 2009, the Company had $4.88 million in loans of this
type.  The unused or unfunded amount on these types of loans totaled
$.84 million as of March 31, 2009.





NOTE G - COLLATERALIZED NOTES
PAYBLE





The Company borrows funds through the
issuance of notes payable which are collateralized by other real estate
owned.  The following table lists the collateralized notes which are
outstanding at March 31, 2009:






Interest
      rate
            
            Due
      Date
            
            Amount
      Owed
            
            Payment
      Terms10.00
            %
            6/1/2009
            
            $
            207,000
            
            Balance
      at 3/31/09 $200,000 with monthly interest only payments due 1st
      of each month.10.00
            %
            6/1/2009
            
            $
            207,000
            
            Interest
      only payments due 1st
      of each month.10.00
            %
            6/1/2009
            
            $
            205,086
            
            Interest
      only payments due 1st
      of each month.8.00
            %
            6/5/2009
            
            $
            100,000
            
            Interest
      only payments due 1st
      of each month.10.00
            %
            12/31/2009
            
            $
            200,000
            
            Interest
      only payments due monthly.10.00
            %
            12/31/2009
            
            $
            125,000
            
            Interest
      only payments due monthly.10.00
            %
            12/31/2009
            
            $
            200,000
            
            Interest
      only payments due monthly.7.5
            %
            3/1/2010
            
            $
            500,000
            
            Monthly
      payment of $6,000 principal plus interest earned7.5
            %
            6/25/2010
            
            $
            200,000
            
            Interest
      accrued with principal curtailments as requested7.5
            %
            1/31/2010
            
            $
            628,656
            
            Interest
      accrued with principal curtailments as requestedTotal
      Collateralized Notes Payable
            
            
            
            $
            2,572,742




NOTE
H - LOAN PARTICIPATIONS SOLD WITH RECOURSE




During
2008, the Company entered into four  loan participation agreements
totaling $4.36 million and paid down one existing participation agreement in the
amount of $50,000.  During the first quarter of 2009, the Company paid
down the existing agreements in the amount of $17,836 and did not enter into any
additional agreements.  These agreements are made with recourse and
there is limited liability on the part of the
participant.  Additionally, if the loan defaults the loan is due on
demand.  The details of the agreements are as follows.





Interest
      Rate
            
            Date
      Due
            
            Amount
      owed
            
            Payment
      Terms12.50
            %
            10/24/2008
            
            $
            203,764
            
            Interest
      only payment monthly10.00
            %
            6/1/2010
            
            $
            451,000
            
            Interest
      only payment monthly12.50
            %
            6/1/2010
            
            $
            889,000
            
            Interest
      only payment monthly9.04
            %
            at
      maturity
            
            $
            2,502,121
            
            Interest
      and principal payment monthly10.00
            %
            at
      maturity
            
            $
            390,977
            
            Interest
      and principal payment monthlyTotal
      Loans Sold with Recourse
            
            
            
            $
            4,436,862




On
October 24, 2007, the Company sold a loan participation with recourse, in the
amount of $261,764, which was to be repaid upon the earlier of October 24, 2008
or the date of the collection of the loan.  The loan has not been
fully repaid and the Company and the participant are working together to collect
on the loan and satisfy the Company’s obligations to the
participant.  The Company has recorded a $203,764 liability on its
books as of March 31, 2009 related to this obligation.




- 12
-
 Table of Contents




NOTE  I
- 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  itsdevelop 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 March 31, 2009,
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.




Assets
and Liabilities Recorded as Fair Value on a Nonrecurring Basis




The
Company may be required from time to time to measure certain assets at fair
value on a nonrecurring basis in accordance with GAAP. These include assets that
are measured at the lower of cost or market that were recognized at fair value
below cost at March 31, 2009.  Assets measured at fair value on a
nonrecurring basis 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
            
            $
            4,207,067
            
            
            
            
            
            $
            4,207,067Other
      Real Estate Owned -Held for sale
            
            $
            3,983,069
            
            
            
            
            
            
            $
            3,983,069






- 13
-
 Table of Contents




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 periodic 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”, “we”, “our” and “us” refer to KH Funding
Company.




Recent
Developments




The registration statement declared
effective on November 10, 2008 covering the sale of our series 3 and series 4
investor notes expired on April 30, 2009 and needs to be amended to provide
current financial information and declared effective by our securities
regulators before we can resume our offering.  Until we can recommence
selling our investor notes, we believe that our ability to generate funds
necessary for operations will be limited.  Although we intend to file
an amended registration statement as soon as possible, there can be no assurance
as to when this will occur or when our securities regulators will declare it
effective.




The
Company is in the process of selling all of its Other Real Estate Owned of about
$3.98 million and has already listed for sale about $2 million of the
properties.  The Company is also aggressively pursuing the collection
of $4.21 million in impaired loans on its books at March 31,
2009.  Through these efforts, we hope to raise cash on the
non-interest earning assets that we hold, which will be used to make investor
redemptions and fund new loans.




Recent
Government Actions




In recent
months, the United States Congress, the United States Department of the Treasury
and various federal regulators have taken steps to control the financial crises
affecting the banking system and financial markets and going concern threats to
investment banks and other financial institutions.  These steps have
included the enactment of the Emergency Economic Stabilization Act of 2008, the
American Recovery and Reinvestment Act of 2009, the Treasury’s Troubled Asset
Relief Program Capital Purchase Plan and Capital Assistance Program, and the
Federal Deposit Insurance Corporation’s Temporary Liquidity Guarantee
Program.  These laws and programs 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.




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.




- 14
-
 Table of Contents




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 were unable to sell any of our investor notes between May 2006 and November
2008 and had only a limited window of selling between November 2008, when our
most recent registration statement became effective, and April 30, 2009, when it
expired.  While we were unable to sell our investor notes, our
operations were funded solely through loan pay-offs, interest and other income
received on our loans, and unsecured short-term borrowings.




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 once we have an effective registration statement for such
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 a signed selling agreement with a FINRA
registered broker-dealer with a network of over 400 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 was very successful, establishing close to 700 new investment accounts
providing us with over $25,000,000 in funds.  In the first four months
of 2006, sales by these broker-dealers established another 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 FINRA 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 because of delays in registering our offering of such
notes.  Our most recent registration statement was declared effective
on November 10, 2008 but expired on April 30, 2009.  We are working to
file an amendment to this registration statement to add the information
necessary for us to begin selling again.  There can be no assurance as
to when this amendment will be filed or when it will be declared effective by
our securities regulators.  Moreover, even if our registration
statement is amended and declared effective, 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.




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 March 31, 2009 our sub-prime loans amounted to only $2.79
million, or 8.44% 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.




- 15
-
 Table of Contents




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-K for the year ended December 31, 2008.  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 March 31, 2009 and December 31, 2008




Assets.  Total
assets increased by $0.63 million, from $44.85 million at December 31, 2008 to
$45.48 million at March 31, 2009, as a result of the acceptance by the Company
of real estate for sale valued at $1.1 million for payment of $0.46 million of
default interest due on a loan receivable with the balance of the payment going
to notes payable.  The size of our loan portfolio increased $0.04
million ending at $36.90 million.




Liabilities.  Total
liabilities increased by $0.49 million, from $45.23 million at December 31,
2008 to $45.72 million at March 31, 2009, as a result of an increase in
collateralized notes payable of $0.90 million and a decrease in notes payable of
$0.36 million.




Stockholders’
Deficit.  Total stockholders’ deficit decreased by $0.15
million from ($0.38) million at December 31, 2008 to ($0.23) million at March
31, 2009.  The decrease was due to the issuance of $500,000 in common
stock with the offsetting net loss of $348,113 and the stock based compensation
expense of $4,268.




Past Due Loans.  As
of March 31, 2009, we held 20 loans that were more than 90 days past due but
still accruing interest, compared to 21 loans as of December 31,
2008.  The total principal and interest due on these loans was
$6,675,110, compared to $10,006,949 as of December 31, 2008.  Fifteen
of the loans, totaling $6,277,744, are first mortgage loans on which we do not
expect to suffer any loss due to the underlying collateral
values.  The borrowers under the remaining five loans, totaling
$397,366, are making scheduled payments or are expected to continue making
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.




Non-Accrual
Loans.  As of March 31, 2009, there were 18 loans in
non-accrual status with an outstanding principal balance totaling $4,207,067,
compared to 20 loans as of December 31, 2008 with an outstanding principal
balance of $4,293,790.  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 March 31, 2009, we had a specific reserve of
$385,059 and a general reserve of $247,600 as part of our total reserve of
$632,659 for anticipated and unanticipated loan losses.




Comparison
of Operating Results for Three Months Ended March 31, 2009 and 2008




Net interest margin. The
average yield earned on loans receivable was 9.43% for the three months ended
March 31, 2009 and 10.32% for the three months ended March 31,
2008.  The average rate paid on investor notes decreased to 6.03% for
the three months ended March 31, 2009 from 6.91% for the three months ended
March 31, 2008, due primarily to a decrease in the contractual rates we are
required to pay on investor notes. Overall, the net margin on interest was 3.40%
for the three months ended March 31, 2009, compared to 3.41% for the three
months ended March 31, 2008.  This net margin is calculated using
contractual rates and excludes fee income and expense.  The Company
does not expect any further significant decrease in the net margin.




- 16
-
 Table of Contents




Net Loss.  Net loss
for the three months ended March 31, 2009 was $348,113, compared to a net loss
of $94,923 for the three months ended March 31, 2008.  The difference
was primarily due to a decrease in net interest income, from $1.21 million to
$0.81 million, because of a decrease in interest earning assets and an increase
in professional fees.




Interest
Income.  Total interest income was $811,869 for the three
months ended March 31, 2009, compared to $1,214,182 for the same period in
2008.  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 $734,236 for the three months
ended March 31, 2009, and $969,480 for the corresponding period in
2008.  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 33,728 for the three
months ended March 31, 2009 and $79,098 for the three months ended March 31,
2008.  These provisions adjusted 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 $22,176 during the three
months ended March 31, 2009, compared to $29,669 for the corresponding period in
2008.  The difference was due primarily to an increase in rental
income and an offsetting loss on the sale of a fixed asset.




Non-Interest
Expense.  We experienced an increase in non-interest expense to
$414,195 for the three months ended March 31, 2009 from $290,196 for the three
months ended March 31, 2008.  Professional fees, real estate
maintenance and offering costs were the major causes of the
increases.




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 March 31, 2009, we had cash and cash
equivalents of $49,900, or 0.11% of total assets, a historically low level,
compared to $221,463 at December 31, 2008 (0.49% of total assets) and $88,391
(0.17% of total assets) at March 31, 2008.  During the first three
months of 2009, we received approximately $0.53 million in loan payments, which
included unscheduled prepayments and payments due at maturity, and we paid
approximately $2.42 million to redeem investor notes.  During the same
period of 2008, we received approximately $5.84 million in loan payments, and we
paid approximately $7.85 million to redeem investor notes.




For the three months ended March 31,
2009, net cash used by operating activities was $77,584, compared to $1,672,024
that was provided by operating activities for the three months ended March 31,
2008.  The primary reason for the decrease was a $1,019,969 reduction
in interest receivable on loans in the first quarter of 2008.




For the three months ended March 31,
2009, net cash provided by investing activities was $115,640, compared to
$1,482,834 for the same period in 2008.  Cash provided by investing
activities for the first quarter of 2009 included $531,461 in principal
repayments on loans receivable offset by $270,868 in loans made to borrowers,
compared to $5,841,137 in principal repayments on loans receivable and
$4,265,201 in offsetting loans made to borrowers for the first quarter of
2008.




For the three months ended March 31,
2009, net cash used in financing activities was $209,619, compared to $3,162,089
for the same period in 2008.  During the 2009 period, net proceeds
from the sale of collateralized note payables were $1,103,636 and proceeds from
the sale of investor notes were $1,122,803, while investor note redemptions
during the same period totaled $2,417,148.




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 enjoyed only a
limited period of time during the past three years (from November 2008 to April
2009) during which we were able to raise cash for operations through the sale of
our investor notes, and this inability to raise significant funds has
substantially hampered our business operations and put stresses on the Company,
including on its ability to timely meet its redemption and other payment
obligations under its investor notes.  Although we are working to file
the necessary information with our securities regulators to have our offering
reinstated, there can be no guaranty as to when this might
occur.  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.




- 17
-
 Table of Contents





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, 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 March 31, 2009, we held
approximately $28.77 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. In the current market, however, we
believe that the prices we could obtain on our saleable assets would probably be
below par and, therefore, we are instead focusing on selling our non-interest
earning assets to satisfy pending investor redemption
requests. Further, we held $1.60 million in business
line-of-credit loans and second mortgage loans at March 31, 2009, which earn
higher yields than the first mortgage 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.




Because of the legal and market factors
discussed above, we may not always be able to sell loans or other assets to meet
redemption requests within the 30-day grace period.  As of the filing
date of this report we were subject to redemption requests with respect to
approximately $0.90 million of outstanding investor notes that are within the
30-day grace period for repayment and redemption requests of $1.50 million of
outstanding series 3 investor notes that are beyond the 30-day grace period for
repayment.  For those notes that are beyond the grace period, we have
either obtained waivers from each of the note holders or are working to obtain
waivers.  In addition, we are more than 30 days late in satisfying our
payment obligations with respect to approximately $1.79 million of our series 3
and series 4 investor notes that have matured.  Accordingly, we are in
default under the Indenture. To date, neither the Indenture Trustee, to whom we
make regular reports regarding redemption status and late payments, nor the
holders of at least 25% of the aggregate amount of outstanding investor notes
have notified us that they intend to accelerate all outstanding notes because of
this event of default, but, as noted above, they have the ability to do so for
so long as our default continues.




The balances of our outstanding
investor notes at March 31, 2009 are as follows:




Series
      3 Demand Notes
            
            BalanceOne
      Day
            
            $
            5,230,410Thirty
      Day
            
            $
            10,414,860Series
      3 Fixed Term Notes:Due
      within 1 year
            
            $
            8,652,606Due
      in 1 to 3 years
            
            $
            5,477,512Due
      in 3 to 5 years
            
            $
            6,071,111Series
      4 Fixed Term Notes:Due
      within 1 year
            
            $
            943,410Due
      in 1 to 3 years
            
            $
            330,912Due
      in 3 to 5 years
            
            $
            1,401,717


Subtotal
            
            $
            38,522,538Unamortized
      brokerage costs
            
            
            (58,607
            )Total
      investor notes, net
            
            $
            38,463,931






- 18
-
 Table of Contents




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’
Deficit.  Total stockholders’ equity has decreased as a
percentage of total assets over the last nine years, from 10.6% at December 31,
1999 to (0.35%) at March 31, 2009.  During the three-month period
ended March 31, 2009, we experienced an operating loss of $348,113 combined with
stock issuances of $500,000 resulting in an ending stockholders deficit of
($225,975).  Our Board suspended the payment of cash dividends after
the second quarter of 2007 to help maintain sufficient equity
levels.




Item 4.  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 March 31, 2009 was carried out under the
supervision and with the participation of the Company’s management, including
the CEO.  Based on that evaluation, the Company’s management,
including the CEO, has concluded that the Company’s disclosure controls and
procedures are, in fact, effective at the reasonable assurance
level.




During the first quarter of 2009, there
was no change in the Company’s internal control over financial reporting that
has materially affected, or is reasonably likely to materially affect, the
Company’s internal control over financial reporting.




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 since been served with legal process.  This
litigation relates to the actions of Martin Angeli, our former Senior Vice
President. 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.




- 19
-
 Table of Contents





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 1A.  Risk Factors




The risks
and uncertainties to which our financial condition and operations are subject
are discussed in detail in Item 1A of Part I of our Annual Report on Form 10-K
for the year ended December 31, 2008.




Item 3.  Defaults Upon Senior Securities




The information required by this item
is contained in Item 2 of Part I of this report under the heading “Liquidity and
Capital Resources” and is incorporated by reference herein.




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.






- 20
-
 Table of Contents




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:  May
      20, 2009
            /s/
      Robert L. HarrisRobert
      L. HarrisPresident,
      Chief Executive Officer, and Acting Chief Financial
Officer






- 21
-
 Table of Contents




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).