UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C.  20549








FORM
10-Q





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





For the
Quarterly Period Ended September 30, 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 £ No £ (Not Yet
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 September 30,
2009.





INDEX





PagePart
      I.  Financial Information
                
                3Item
      1.  Financial Statements
                
                3Balance
      Sheets - September 30, 2009 (unaudited) and December 31,
    2008
                
                3Statements
      of Operations (unaudited) - For the three and nine months ended September
      30, 2009 and 2008
                
                4Statements
      of Changes in Stockholders’ Deficit (unaudited) - For the nine months
      ended September 30, 2009 and 2008
                
                5Statements
      of Cash Flows (unaudited) - For the nine months ended September 30, 2009
      and 2008
                
                6Notes
      to Interim Financial Statements (unaudited)
                
                7Item
      2.  Management’s Discussion and Analysis of Financial Condition
      and Results of Operations
                
                15Item
      4.  Controls and Procedures
                
                22Part
      II.  Other Information
                
                22Item
      1.  Legal Proceedings
                
                22Item
      1A.  Risk Factors
                
                23Item
      3.  Defaults Upon Senior Securities
                
                23Item
      6.  Exhibits
                
                23Signatures
                
                23Exhibit
      Index
                
                24


-2-


PART
I – FINANCIAL INFORMATION





Item
1.  Financial Statements.





KH
FUNDING COMPANY


BALANCE
SHEETS





September 30,
                        2009
                      
                      
                      December 31,
                        2008(unaudited)AssetsCash
                      
                      $
                      28,377
                      
                      
                      $
                      221,463Loans
      receivable, less allowance for loan losses of $866,148(September
      30, 2009) and $659,242 (December 31, 2008)
                      
                      
                      33,972,617
                      
                      
                      
                      36,860,118Accrued
      interest receivable
                      
                      
                      2,127,369
                      
                      
                      
                      2,155,100Other
      receivables
                      
                      
                      388,013
                      
                      
                      
                      542,718Prepaid
      expenses
                      
                      
                      206,229
                      
                      
                      
                      219,458Property
      and equipment – net
                      
                      
                      56,160
                      
                      
                      
                      101,070Real
      estate owned:Rental
      property
                      
                      
                      1,903,976
                      
                      
                      
                      2,079,374Held
      for sale
                      
                      
                      3,672,259
                      
                      
                      
                      2,652,069Other
      assets
                      
                      
                      15,988
                      
                      
                      
                      15,988Total
      Assets
                      
                      $
                      42,370,988
                      
                      
                      $
                      44,847,358Liabilities
      and Stockholders’ DeficitLiabilitiesNotes
      and accrued interest payable
                      
                      $
                      37,658,594
                      
                      
                      $
                      38,828,923Other
      loans payable
                      
                      
                      14,772
                      
                      
                      
                      92,408Accounts
      payable and accrued expenses
                      
                      
                      224,088
                      
                      
                      
                      42,705Escrows
      and security deposits
                      
                      
                      65,028
                      
                      
                      
                      81,115Long-term
      liabilities
                      
                      
                      51,170
                      
                      
                      
                      50,857Loans
      sold with recourse
                      
                      
                      3,527,534
                      
                      
                      
                      4,454,698Collateralized
      notes payable
                      
                      
                      2,298,446
                      
                      
                      
                      1,678,782Total
      Liabilities
                      
                      
                      43,839,632
                      
                      
                      
                      45,229,488Stockholders’
      DeficitCommon
      stock (5,000,000 shares authorized; 3,074,981 shares  (September
      30, 2009) and 2,574,981 shares (December 31, 2008) issued and outstanding,
      $0.01 par value)
                      
                      
                      30,750
                      
                      
                      
                      25,750Paid-in
      capital
                      
                      
                      1,955,505
                      
                      
                      
                      1,448,738Accumulated
      deficit
                      
                      
                      (3,269,449
                      )
                      
                      
                      (1,671,168
                      )Subscription
      note receivable
                      
                      
                      (185,450
                      )
                      
                      
                      (185,450
                      )Total
      Stockholders’ Deficit
                      
                      
                      (1,468,644
                      )
                      
                      
                      (382,130
                      )Total
      Liabilities and Stockholders’ Deficit
                      
                      $
                      42,370,988
                      
                      
                      $
                      44,847,358





The
accompanying notes are an integral part of these statements.


-3-


KH
FUNDING COMPANY


STATEMENTS
OF OPERATIONS (UNAUDITED)





For the Three
                                                          Months
                                                          Ended September 30,
                                                        
                                                        
                                                        For the nine
                                                          Months
                                                          Ended September 30,2009
                                                        
                                                        
                                                        2008
                                                        
                                                        
                                                        2009
                                                        
                                                        
                                                        2008Interest
      IncomeInterest
      and fees on loans
                                                        
                                                        $
                                                        754,710
                                                        
                                                        
                                                        $
                                                        989,599
                                                        
                                                        
                                                        $
                                                        2,361,788
                                                        
                                                        
                                                        $
                                                        3,256,046Interest
      on bank accounts
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        30
                                                        
                                                        
                                                        
                                                        2
                                                        
                                                        
                                                        
                                                        108Total
      interest income
                                                        
                                                        
                                                        754,710
                                                        
                                                        
                                                        
                                                        989,629
                                                        
                                                        
                                                        
                                                        2,361,790
                                                        
                                                        
                                                        
                                                        3,256,154Interest
      ExpenseInterest
      and fees on notes
                                                        
                                                        
                                                        626,778
                                                        
                                                        
                                                        
                                                        690,752
                                                        
                                                        
                                                        
                                                        1,846,930
                                                        
                                                        
                                                        
                                                        2,314,668Interest
      on other loans
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        27,312
                                                        
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        133,687Interest
      on participation loans
                                                        
                                                        
                                                        113,668
                                                        
                                                        
                                                        
                                                        117,929
                                                        
                                                        
                                                        
                                                        388,324
                                                        
                                                        
                                                        
                                                        229,590Total
      interest expense
                                                        
                                                        
                                                        740,446
                                                        
                                                        
                                                        
                                                        835,993
                                                        
                                                        
                                                        
                                                        2,235,254
                                                        
                                                        
                                                        
                                                        2,677,945Net
      interest income
                                                        
                                                        
                                                        14,264
                                                        
                                                        
                                                        
                                                        153,636
                                                        
                                                        
                                                        
                                                        126,536
                                                        
                                                        
                                                        
                                                        578,209Provision
      for Loan Losses
                                                        
                                                        
                                                        271,569
                                                        
                                                        
                                                        
                                                        118,286
                                                        
                                                        
                                                        
                                                        624,607
                                                        
                                                        
                                                        
                                                        272,384Net
      Interest Income after Provision for Loan Losses
                                                        
                                                        
                                                        (257,305
                                                        )
                                                        
                                                        
                                                        35,350
                                                        
                                                        
                                                        
                                                        (498,071
                                                        )
                                                        
                                                        
                                                        305,825Non-interest
      (Loss) IncomeRental
      income
                                                        
                                                        
                                                        23,446
                                                        
                                                        
                                                        
                                                        40,995
                                                        
                                                        
                                                        
                                                        93,021
                                                        
                                                        
                                                        
                                                        90,038Loss
      on sale of real estate owned
                                                        
                                                        
                                                        (170,639
                                                        )
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        (156,991
                                                        )
                                                        
                                                        
                                                        (4,732
                                                        )Loss
      on the sale of fixed asset
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        (10,906
                                                        )
                                                        
                                                        
                                                        -Other
                                                        
                                                        
                                                        2,245
                                                        
                                                        
                                                        
                                                        637
                                                        
                                                        
                                                        
                                                        3,344
                                                        
                                                        
                                                        
                                                        9,212Total
      non-interest (loss) income
                                                        
                                                        
                                                        (144,948
                                                        )
                                                        
                                                        
                                                        41,632
                                                        
                                                        
                                                        
                                                        (71,532
                                                        )
                                                        
                                                        
                                                        94,518Non-interest
      ExpenseSalaries
      and wages
                                                        
                                                        
                                                        71,515
                                                        
                                                        
                                                        
                                                        75,672
                                                        
                                                        
                                                        
                                                        233,843
                                                        
                                                        
                                                        
                                                        244,108Professional
      fees
                                                        
                                                        
                                                        58,282
                                                        
                                                        
                                                        
                                                        19,612
                                                        
                                                        
                                                        
                                                        326,583
                                                        
                                                        
                                                        
                                                        124,144Offering
      costs
                                                        
                                                        
                                                        31,406
                                                        
                                                        
                                                        
                                                        32,235
                                                        
                                                        
                                                        
                                                        110,010
                                                        
                                                        
                                                        
                                                        104,438Administration
                                                        
                                                        
                                                        10,073
                                                        
                                                        
                                                        
                                                        11,414
                                                        
                                                        
                                                        
                                                        35,023
                                                        
                                                        
                                                        
                                                        61,088Real
      estate maintenance
                                                        
                                                        
                                                        38,537
                                                        
                                                        
                                                        
                                                        32,211
                                                        
                                                        
                                                        
                                                        101,249
                                                        
                                                        
                                                        
                                                        87,589Insurance
                                                        
                                                        
                                                        5,758
                                                        
                                                        
                                                        
                                                        17,219
                                                        
                                                        
                                                        
                                                        33,982
                                                        
                                                        
                                                        
                                                        55,850Depreciation
                                                        
                                                        
                                                        12,626
                                                        
                                                        
                                                        
                                                        16,824
                                                        
                                                        
                                                        
                                                        49,240
                                                        
                                                        
                                                        
                                                        47,163Rent
                                                        
                                                        
                                                        28,853
                                                        
                                                        
                                                        
                                                        28,590
                                                        
                                                        
                                                        
                                                        88,456
                                                        
                                                        
                                                        
                                                        86,506Bank
      charges
                                                        
                                                        
                                                        1,192
                                                        
                                                        
                                                        
                                                        14,334
                                                        
                                                        
                                                        
                                                        24,849
                                                        
                                                        
                                                        
                                                        41,127Stock
      based compensation
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        2,781
                                                        
                                                        
                                                        
                                                        11,766
                                                        
                                                        
                                                        
                                                        10,573Other
                                                        
                                                        
                                                        6,294
                                                        
                                                        
                                                        
                                                        8,031
                                                        
                                                        
                                                        
                                                        13,677
                                                        
                                                        
                                                        
                                                        12,601Total
      non-interest expense
                                                        
                                                        
                                                        264,536
                                                        
                                                        
                                                        
                                                        258,923
                                                        
                                                        
                                                        
                                                        1,028,678
                                                        
                                                        
                                                        
                                                        875,187Net
      Loss
                                                        
                                                        $
                                                        (666,789
                                                        )
                                                        
                                                        $
                                                        (181,941
                                                        )
                                                        
                                                        $
                                                        (1,598,281
                                                        )
                                                        
                                                        $
                                                        (474,844
                                                        )Basic
      and diluted loss per share
                                                        
                                                        $
                                                        (0.22
                                                        )
                                                        
                                                        $
                                                        (0.07
                                                        )
                                                        
                                                        $
                                                        (0.53
                                                        )
                                                        
                                                        $
                                                        (0.18
                                                        )Cash
      dividends paid per common share
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        -





The
accompanying notes are an integral part of these
statements.


-4-





KH
FUNDING COMPANY


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


FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2009 and 2008





Common Stock
                      
                      
                      Paid-In
                      
                      
                      Accumulated
                      
                      
                      Subscription Note
                      
                      
                      Total
                        Stockholders’
                        EquityShares
                      
                      
                      Amount
                      
                      
                      Capital
                      
                      
                      Deficit
                      
                      
                      Receivable
                      
                      
                      (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
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      10,573
                      
                      
                      
                      –
                      
                      
                      
                      –
                      
                      
                      
                      10,573Net
      loss for period ended September 30, 2008
                      
                      
                      –
                      
                      
                      
                      –
                      
                      
                      
                      –
                      
                      
                      
                      (474,844
                      )
                      
                      
                      –
                      
                      
                      
                      (474,844
                      )Balances
      at September 30, 2008
                      
                      
                      2,574,981
                      
                      
                      $
                      25,750
                      
                      
                      $
                      1,442,984
                      
                      
                      $
                      (1,008,489
                      )
                      
                      $
                      (185,450
                      )
                      
                      $
                      274,795Balances
      at January 1, 2009
                      
                      
                      2,574,981
                      
                      
                      $
                      25,750
                      
                      
                      $
                      1,448,738
                      
                      
                      $
                      (1,671,168
                      )
                      
                      $
                      (185,450
                      )
                      
                      $
                      (382,130
                      )Additional
      stock issued
                      
                      
                      500,000
                      
                      
                      
                      5,000
                      
                      
                      
                      495,000
                      
                      
                      
                      –
                      
                      
                      
                      –
                      
                      
                      
                      500,000Stock
      Based Compensation Expense
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      11,767
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      11,767Net
      loss for period ended September 30, 2009
                      
                      
                      –
                      
                      
                      
                      –
                      
                      
                      
                      –
                      
                      
                      
                      (1,598,281
                      )
                      
                      
                      –
                      
                      
                      
                      (1,598,281
                      )Balances
      at September 30, 2009
                      
                      
                      3,074,981
                      
                      
                      $
                      30,750
                      
                      
                      $
                      1,955,505
                      
                      
                      $
                      (3,269,449
                      )
                      
                      $
                      (185,450
                      )
                      
                      $
                      (1,468,644
                      )





The
accompanying notes are an integral part of these
statements.


-5-


KH
FUNDING COMPANY


STATEMENTS
OF CASH FLOWS (UNAUDITED)





For the nine months ended September 30,2009
                
                
                
                2008Cash
      Flows from Operating ActivitiesNet
      loss
                
                $
                (1,598,281
                )
                
                $
                (474,844
                )Adjustments
      to Reconcile Net Income to Net Cash from Operating
    Activities:Depreciation
                
                
                49,240
                
                
                
                47,165Amortization
      of loan fees
                
                
                (10,992
                )
                
                
                (22,108
                )Provision
      for loan losses
                
                
                624,607
                
                
                
                272,384Loss
      on sale of real estate owned
                
                
                150,529
                
                
                
                4,732Loss
      on sale of property and equipment
                
                
                10,907Stock
      based compensation expense
                
                
                11,767
                
                
                
                10,573Write-down
      on real estate held for sale
                
                
                -
                
                
                
                37,954Changes
      in Operating Assets and LiabilitiesAccrued
      late charges
                
                
                (28,666
                )
                
                
                (27,235
                )Prepaid
      expenses
                
                
                (12,172
                )
                
                
                30,008Interest
      receivable
                
                
                (631,499
                )
                
                
                662,496Interest
      payable (included in notes payable)
                
                
                1,200,302
                
                
                
                1,369,899Accounts
      payable and accrued expenses
                
                
                181,383
                
                
                
                4,198Prepaid
      offering costs
                
                
                25,401
                
                
                
                (9,408
                )Deferred
      loan origination costs
                
                
                9,000
                
                
                
                9,900Unamortized
      brokerage fees
                
                
                29,700
                
                
                
                50,000Long-term
      liabilities
                
                
                313
                
                
                
                7,886Prepaid
      loan expenses
                
                
                76,500
                
                
                
                76,797Net
      Cash Provided by Operating Activities
                
                
                88,039
                
                
                
                2,050,397Cash
      Flows from Investing ActivitiesPrincipal
      repayments from borrowers
                
                
                2,695,283
                
                
                
                10,695,201Loans
      made to borrowers
                
                
                (623,533
                )
                
                
                (6,093,811
                )Net
      other receivables
                
                
                (90,537
                )
                
                
                (136,186
                )Proceeds
      from sale of real estate owned
                
                
                840,208
                
                
                
                16,151Proceeds
      from the sale of fixed assets
                
                
                10,000
                
                
                
                -Payments
      related to other real estate owned
                
                
                (1,699
                )
                
                
                (14,285
                )Net
      Cash Provided by Investing Activities
                
                
                2,829,722
                
                
                
                4,467,070Cash
      Flows from Financing ActivitiesProceeds
      from investor notes
                
                
                1,587,775
                
                
                
                1,397,180Principal
      payments on investor notes
                
                
                (4,591,372
                )
                
                
                (13,352,867
                )(Payments)
      proceeds from loans sold with recourse
                
                
                (927,164
                )
                
                
                4,804,058Proceeds
      from collateralized notes payable
                
                
                829,340
                
                
                
                -Proceeds
      from short term borrowings
                
                
                14,772
                
                
                
                848,793Redemption
      of common stock
                
                
                -
                
                
                
                (300,000
                )(Decrease)
      increase in escrow and security deposits
                
                
                (24,198
                )
                
                
                2,113Net
      Cash Used in Financing Activities
                
                
                (3,110,847
                )
                
                
                (6,600,723
                )Net
      Decrease in Cash
                
                
                (193,086
                )
                
                
                (83,256
                )Cash Balance, beginning
      of period
                
                
                221,463
                
                
                
                95,622Cash Balance,end of
      period
                
                $
                28,377
                
                
                $
                12,366Supplemental
      Cash Flow Information:Interest
      paid
                
                $
                554,888
                
                
                $
                1,308,046Transfer
      of loans to real estate owned
                
                $
                766,948
                
                
                $
                1,031,280




The
accompanying notes are an integral part of these statements.


-6-


KH
Funding Company


Notes to
Interim Financial Statements


For the
Nine Months Ended September, 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 September 30, 2009, the results of
operations for the three- and nine-month periods ended September 30, 2009 and
2008, changes in stockholders’ (deficit) equity for the nine-month periods ended
September 30, 2009 and 2008, and cash flows for the nine-month periods ended
September 30, 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- and nine-month periods ended September 30, 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’s sources of
liquidity have been limited over the past two and one-half years, primarily
because it experienced significant delays starting in the second quarter of 2006
in obtaining an effective registration statement covering the offer and sale of
investor notes.  The Company requires cash to make and acquire loans,
redeem outstanding investor notes, and pay other operational
expenses.  Investor notes, along with loan payments, are the Company’s
principal sources of liquidity, so an inability to publicly offer investor notes
presents significant risks to the Company’s ability to continue as a going
concern.  The Company’s most recent registration statement, covering
the offer and sale of an aggregate of $250 million of our Series 3 Secured Notes
and Series 4 Unsecured Notes, was declared effective by the Securities and
Exchange Commission (the “SEC”) and by the Maryland Division of Securities on
November 10, 2008.  The registration statement expired on April 30,
2009.  Additionally, stockholders’ deficit at September 30, 2009 has
increased to (3.47%) of total assets, which the Company believes to be
inadequate to fully protect it against potential losses.





The lack of liquidity has significant
and adversely impacted the Company’s ability to timely satisfy redemption
requests from the holders of its outstanding investor notes.  As of
September 30, 2009, the Company was subject to repayment and redemption requests
with respect to approximately $3.67 million of outstanding investor notes that
are beyond the 30-day grace period for payment, and the Company has not obtained
waivers from all of these holders.  Accordingly, the Company is in
default under the Indenture.  Holders of the Company's one-day demand
investor notes can request a redemption immediately after investment, and the
Company is required to redeem the note within one day after receiving the
request.  Holders of the Company's thirty-day demand investor notes
can likewise request a redemption immediately after investment, but the Company
is not required to redeem the note until 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.  The Company will be in default under the Indenture
relating to these notes if the Company fails to satisfy a redemption request
within 30 days of the date set for redemption, unless the Company obtains a
waiver from each of the note holders who has 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 the 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 acceleration would likely
require the Company to liquidate the Company.  To date, neither the
Indenture Trustee, to whom the Company makes 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 the Company that
they intend to accelerate all outstanding notes because of this
default.





Because the Company is currently in
default with respect to some of its outstanding investor notes, because both
future income from loans and cash needed for operations, including investor note
redemptions, are uncertain, and because the Company cannot predict whether its
efforts to obtain an effective registration for investor notes—or any offering
itself—will be successful, there is substantial doubt about the Company’s
ability to continue as a going concern.  This could impact
dramatically on the ability of investors to receive redemptions.





To remedy the foregoing defaults and to
strengthen the Company’s cash position going forward, the Company intends, as
soon as is practicable, to re-commence efforts to publicly sell investor notes,
although there can be no assurance as to when, or if, this will
occur.  In the mean time, the Company intends to continue monitoring
liquidity carefully and to take steps to create liquidity so that it can meet
its obligations as they become due.  For example, beginning in June
2009, the Company started aggressively marketing other real estate owned held
for sale.  The Company anticipates that the proceeds from sales of
investor notes, if and when it obtains an effective registration, together with
the use of future loan payoff proceeds, will enable it to satisfy current
liquidity needs.  There can be no assurance, however, that any funds
generated from future offerings and from loan payoffs and scheduled payments in
the future will exceed the amounts needed to satisfy current or future
redemption requests and other demands for liquidity.


-7-





In connection with preparation of the
financial statements and based on guidance from the FASB regarding “Subsequent
Events”, the Company evaluated subsequent events after the balance sheet date of
September 30, 2009 through November 16, 2009.





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.





Loss
Per Share





Basic earnings per share is derived by
dividing net losses incurred to common stockholders by the weighted-average
number of common shares outstanding and does not include the effect of any
potentially dilutive common stock equivalents. Diluted 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 during the
period.  As of September 30, 2009 and September 30, 2008, the Company
had outstanding stock options to purchase 80,000 and 241,250 shares of common
stock, respectively. All options were excluded from the computation of dilutive
loss per share as their effect would have been anti-dilutive.





For The Three
                            Months Ended
                            September 30,
                          
                          
                          For The Nine
                            Months Ended
                            September 30,2009
                          
                          
                          2008
                          
                          
                          2009
                          
                          
                          2008(unaudited)
                          
                          
                          (unaudited)Basic:Net
      loss (attributable to common stock)
                          
                          $
                          (666,789
                          )
                          
                          $
                          (181,941
                          )
                          
                          $
                          (1,598,281
                          )
                          
                          $
                          (474,844
                          )Weighted
      average common shares outstanding
                          
                          
                          3,074,981
                          
                          
                          
                          2,574,981
                          
                          
                          
                          3,034,688
                          
                          
                          
                          2,574,981Basic
      loss per share
                          
                          $
                          (0.22
                          )
                          
                          $
                          (0.07
                          )
                          
                          $
                          (0.53
                          )
                          
                          $
                          (0.18
                          )Diluted:Net
      loss (attributable to common stock)
                          
                          $
                          (666,789
                          )
                          
                          $
                          (181,941
                          )
                          
                          $
                          (1,598,281
                          )
                          
                          $
                          (474,844
                          )Weighted
      average common shares outstanding
                          
                          
                          3,074,981
                          
                          
                          
                          2,574,981
                          
                          
                          
                          3,034,688
                          
                          
                          
                          2,574,981Dilutive
      effect of stock options
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Weighted
      average common shares outstanding-diluted
                          
                          
                          3,074,981
                          
                          
                          
                          2,574,981
                          
                          
                          
                          3,034,688
                          
                          
                          
                          2,574,981Diluted
      loss per share
                          
                          $
                          (0.22
                          )
                          
                          $
                          (0.07
                          )
                          
                          $
                          (0.53
                          )
                          
                          $
                          (0.18
                          )


-8-





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 May 2009, the Financial Accounting
Standards Board (“FASB”) issued guidance concerning subsequent events with
regard to the financial statements.  This FASB guidance requires the
disclosure of the date through which a company has evaluated subsequent events
occurring after the balance sheet date of the financial statements and whether
this date is the date the financial statements were issued or the date the
financial statements were available to be issued.  This new FASB
guidance is effective for financial statements issued for interim or annual
periods ending after June 15, 2009. The implementation of this guidance did not
have a material impact on our financial statements.  The Company has
included the information required by this guidance in Note 1.





In June 2009, the FASB issued a
pronouncement entitled “The
FASB Accounting Standards Codification and the Hierarchy of Generally
Accepted Accounting
Principles” a replacement of prior FASB guidance.  This new
FASB guidance will become the source of authoritative GAAP recognized by the
FASB to be applied by nongovernmental entities. Rules and interpretive releases
of the Securities and Exchange Commission (“SEC”) under authority of federal
securities laws are also sources of authoritative GAAP for SEC registrants. On
the effective date of this new guidance, the Codification will supersede all
then-existing non-SEC accounting and reporting standards. All other
nongrandfathered non-SEC accounting literature not included in the Codification
will become nonauthoritative.  This guidance is effective for
financial statements issued for interim and annual periods ending after
September 15, 2009.  Once the Codification is in effect, all of its
content will carry the same level of authority, effectively superseding prior
FASB guidance.





In June 2009, the FASB issued
guidance regarding “Amendments
to FASB Interpretation No. 46(R)”.  The Board’s
objective in issuing this guidance is to improve financial reporting by
enterprises involved with variable interest entities. This new FASB guidance
shall be effective as of the beginning of each reporting entity’s first annual
reporting period that begins after November 15, 2009, for interim periods within
that first annual reporting period, and for interim and annual reporting periods
thereafter. Earlier application is prohibited.  The Company does not
believe the adoption of this guidance will have a material impact on the
Company’s financial statements.





In June 2009, the FASB issued new
guidance regarding “Accounting
for Transfers of Financial Assets—an amendment of prior FASB
guidance”.  The Board’s objective in issuing this new guidance is to
improve the relevance, representational faithfulness, and comparability of the
information that a reporting entity provides in its financial statements about a
transfer of financial assets; the effects of a transfer on its financial
position, financial performance, and cash flows; and a transferor’s continuing
involvement, if any, in transferred financial assets.  This new FASB
guidance must be applied as of the beginning of each reporting entity’s first
annual reporting period that begins after November 15, 2009, for interim periods
within that first annual reporting period and for interim and annual reporting
periods thereafter. Earlier application is prohibited.   The Company does
not believe the adoption of this guidance will have a material impact on the
Company’s financial statements.





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.


-9-





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.





Impaired
Loans





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





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





September 30,
                      2009
                    
                    
                    December 31,
                      2008(unaudited)Total
      recorded investment in impaired loans
                    
                    $
                    4,215,617
                    
                    
                    $
                    4,043,791Amount
      of that recorded investment for which there is a related allowance for
      loan losses
                    
                    $
                    2,956,135
                    
                    
                    $
                    1,691,398Amount
      of related allowance for loan losses associated with such
      investment
                    
                    $
                    496,515
                    
                    
                    $
                    448,298Amount
      of that recorded investment for which there is no related allowance for
      loan losses
                    
                    $
                    1,259,482
                    
                    
                    $
                    2,352,393





For the nine months
                    ended September 30,
                    2009
                  
                  
                  For the year ended
                    December 31,
                    2008(unaudited)Average
      recorded investment in impaired loans during period
                  
                  $
                  4,129,704
                  
                  
                  $
                  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 September 30, 2009 and December 31,
2008, the Company had loans of $6,570,907 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 nine months
                      ended September
                      30, 2009
                    
                    
                    For the nine months
                      ended September
                      30, 2008(unaudited)
                    
                    
                    (unaudited)Beginning
      balance
                    
                    $
                    659,297
                    
                    
                    $
                    495,480Provision
      for loan losses
                    
                    
                    624,607
                    
                    
                    
                    272,384Loans
      charged off
                    
                    
                    (417,756
                    )
                    
                    
                    (107,440
                    )Ending
      Balance
                    
                    $
                    866,148
                    
                    
                    $
                    660,424


-10-


The
breakdown by loan type of the allowance for loan losses is as
follows:





For the nine months
                      ended September
                      30, 2009
                    
                    
                    For the nine months
                      ended September
                      30, 2008(unaudited)
                    
                    
                    (unaudited)Business
      Loans
                    
                    $
                    85,004
                    
                    
                    $
                    82,360Investment
      Property Loans
                    
                    
                    302,098
                    
                    
                    
                    259,693Medical
      Loans
                    
                    
                    1,588
                    
                    
                    
                    585Other
      Assets
                    
                    
                    -
                    
                    
                    
                    245Real
      Estate Loans
                    
                    
                    219,234
                    
                    
                    
                    144,338Second
      Trust Loans
                    
                    
                    115,993
                    
                    
                    
                    66,152Over
      Equity Loans
                    
                    
                    64,681
                    
                    
                    
                    23,604Unsecured
      Loans
                    
                    
                    77,550
                    
                    
                    
                    83,447$
                    866,148
                    
                    
                    $
                    660,424





Principal Balance
                        As of September 30,
                        2009
                      
                      
                      Charge-Offs for the
                        nine months ended
                        September 30, 2009(unaudited)
                      
                      
                      (unaudited)Business
      Loans
                      
                      $
                      -
                      
                      
                      $
                      2,650Investment
      Property Loans
                      
                      
                      18,655,459
                      
                      
                      
                      130,934Medical
      Loans
                      
                      
                      5,677
                      
                      
                      
                      -Other
      Assets
                      
                      
                      2,021,436
                      
                      
                      
                      -Real
      Estate Loans
                      
                      
                      8,094,993
                      
                      
                      
                      248,244Second
      Trust Loans
                      
                      
                      1,303,982
                      
                      
                      
                      35,928Over
      Equity Loans
                      
                      
                      70,678
                      
                      
                      
                      -Unsecured
      Loans
                      
                      
                      132,310
                      
                      
                      
                      -$
                      30,284,535
                      
                      
                      $
                      417,756





NOTE
D—RELATED PARTY TRANSACTIONS





Included in notes receivable at
September 30, 2009 and December 31, 2008, are 12 notes totaling $11,117,156 and
12 notes totaling $10,788,498, respectively, from officers, stockholders and
entities controlled by a stockholder.  These notes all have annual
maturities and are due in full on the maturity date unless extended by the
Company.  The interest rates on these notes range between 5.99% and
12.5% with a weighted average interest rate of 8.04%. The majority (94.2%) of
these notes receivable were due from one stockholder and its related interests,
who owed $10,475,478 as of September 30, 2009.





Included
in the notes receivable mentioned above at September 30, 2009 and December 31,
2008 are six loans in the amount of $10.48 million and $010.19 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 September 30, 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
September  30, 2009 and December 31, 2008, are 49 notes totaling
$5,976,873 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 September 30, 2009 and December 31, 2008 as contra-equity, made to the
Company’s CEO for the purchase of 100,000 shares of stock in the Company, which
secures the loan.  The interest rate on this loan is 7%.  At
September 30, 2009 and December 31, 2008, all payments under this loan had been
timely made and there was no accrued interest receivable on this
loan.


-11-





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





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





NOTE
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 nine months ended September 30, 2009 or 2008.  During the nine
months ended September 30, 2009, 161,250 options expired.





The
Company accrues related compensation expenses as its options vest in accordance
with FASB guidance regarding Share-Based
Payment.  The Company recognized $11,767 and $10,573
stock-based compensation expense during the nine months ended
September  30, 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 and $0,
respectively, for the nine months ended September 30, 2009 and
2008.





A summary
of stock option activity during the nine months ended September 30, 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
                            
                            
                            161,250
                            
                            
                            
                            2.00
                            
                            
                            
                            
                            
                            
                            -Outstanding
      at September  30, 2009
                            
                            
                            80,000
                            
                            
                            
                            3.19
                            
                            
                            
                            1.78
                            
                            
                            
                            -Exercisable
      at September 30, 2009
                            
                            
                            80,000
                            
                            
                            
                            3.19
                            
                            
                            
                            1.78
                            
                            
                            
                            -





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
September 30, 2009 and their issuance in the only warrant activity for the nine
months then ended.  There were no warrants outstanding at September
30, 2008, nor was there any warrant activity for the nine months then
ended.


-12-


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 September 30, 2009, the Company had $4.88 million in loans of this
type.  The unused or unfunded amount on these types of loans totaled
$0.79 million as of September 30, 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 September 30, 2009:







Interest
                      rate
                    
                    Due Date
                    
                    Amount Owed
                    
                    Payment Terms10.00
                    %
                    12/31/2009
                    
                    $
                    207,000
                    
                    Interest
      only payments due 1st
      of each month.10.00
                    %
                    12/31/2009
                    
                    
                    207,000
                    
                    Interest
      only payments due 1st
      of each month.10.00
                    %
                    12/31/2009
                    
                    
                    205,086
                    
                    Interest
      only payments due 1st
      of each month.8.00
                    %
                    12/5/2009
                    
                    
                    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.7.5
                    %
                    3/1/2010
                    
                    
                    470,000
                    
                    Monthly
      payment of $6,000 principal plus interest earned7.5
                    %
                    8/31/2010
                    
                    
                    200,000
                    
                    Interest
      accrued with principal curtailments as requested7.5
                    %
                    1/31/2010
                    
                    
                    584,360
                    
                    Interest
      accrued with principal curtailments as requestedTotal
      Collateralized Notes Payable
                    
                    
                    
                    
                    
                    
                    $
                    2,298,446





NOTE
H— LOAN PARTICIPATIONS SOLD WITH RECOURSE





From time
to time, the Company sells participation interest in its loans.  The
participation interests are typically sold with recourse to the Company (the
Company’s repurchase obligations are due on demand if the loan defaults) and the
agreements typically provide for limited liability on the part of the holder of
the participation interest.  During the nine-month period ended
September 30, 2008, the Company entered into three such participation agreements
and received a total of $3.18 million and paid down one existing agreement in
the amount of $27,736.  During the same period of 2009, the Company
paid down existing agreements in the amount $927,164 and did not enter into any
additional agreements.  The details of the Company’s existing
participation 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 monthly9.04
                                                            %
                                                            at
      maturity
                                                            
                                                            
                                                            2,483,527
                                                            
                                                            Interest
      and principal payment monthly10.00
                                                            %
                                                            at
      maturity
                                                            
                                                            
                                                            389,243
                                                            
                                                            Interest
      and principal payment monthlyTotal
      Loans Sold with Recourse
                                                            
                                                            
                                                            
                                                            $
                                                            3,527,534
  -13-




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 (listed
above) on its books as of September 30, 2009 related to this
obligation.





NOTE  I—FAIR
VALUE MEASUREMENTS




Recent FASB guidance regarding Fair Value Measurements,
establishes a framework for measuring fair value. That framework provides a fair
value hierarchy that prioritizes the inputs to valuation techniques used to
measure fair value.  The hierarchy gives the highest priority to
unadjusted quoted prices in active markets for identical assets or liabilities
(level 1 measurements) and the lowest priority to unobservable inputs (level 3
measurements).  The three levels of the fair value hierarchy under the
FASB guidance are described as follows:




Level
      1
            Inputs
      to the valuation methodology are unadjusted quoted prices for identical
      assets or liabilities in active markets that the plan has the ability to
      access.





Level
      2
            Inputs
      to the valuation methodology
include:


·
            quoted
      prices for similar assets or liabilities in active
  markets;


·
            quoted
      prices for identical or similar assets or liabilities in inactive
      markets;


·
            inputs
      other than quoted prices that are observable for the asset or
      liability;


·
            inputs
      that are derived principally from or corroborated by observable market
      data by correlation or other means.





If the
asset or liability has a specified (contractual) term, the level 2 input must be
observable for substantially the full term of the asset or
liability.





Level
      3
            Inputs
      to the valuation methodology are unobservable and significant to the fair
      value measurement.







The asset or liability’s fair value
measurement level within the fair value hierarchy is based on the lowest level
of any input that is significant to the fair value
measurement.  Valuation techniques used need to maximize the use of
observable inputs and minimize the use of unobservable inputs.





The following is a description of the
valuation methodologies used for assets measured at fair value.  There
have been no changes in the methodologies used at September 30,
2009.





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
principal 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 FASB guidance regarding “Accounting by Creditors for
Impairment of a Loan”. The fair value of impaired loans is estimated
using one of several methods, including the collateral value, market value of
similar debt, enterprise value, liquidation value and discounted cash flows.
Those impaired loans not requiring a specific allowance represents loans for
which the fair value of expected repayments or collateral exceed the recorded
investment in such loans. At September 30, 2009, substantially all of the
totally impaired loans were evaluated based upon the fair value of the
collateral. In accordance with FASB guidance, 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




We may be
required from time to time to measure certain assets at fair value on a
nonrecurring basis in accordance with U.S. generally accepted accounting
principles. These include assets that are measured at the lower of cost or
market that were recognized at fair value below cost at September 30,
2009.  Assets measured at fair value on a nonrecurring basis are
included in the table below:


-14-





The
carrying values and estimated fair values of financial instruments are
summarized in the following table:





September
      30, 2009Carrying
                  
                  
                  EstimatedValue
                  
                  
                  Fair
      ValueAssets:Cash
                  
                  $
                  28,377
                  
                  
                  $
                  28,377Loans
      receivable
                  
                  
                  33,972,617
                  
                  
                  
                  33,521,722Accrued
      interest receivable
                  
                  
                  2,127,369
                  
                  
                  
                  2,127,369Other
      receivables
                  
                  
                  388,013
                  
                  
                  
                  388,013Real
      estate owed - held for sale
                  
                  
                  3,672,259
                  
                  
                  
                  3,786,540Liabilities:Notes
      and accrued interest payable
                  
                  
                  37,658,594
                  
                  
                  
                  38,388,122Other
      loans payable
                  
                  
                  14,772
                  
                  
                  
                  14,772Loans
      sold with recourse
                  
                  
                  3,527,534
                  
                  
                  
                  3,557,002Collateralized
      notes payable
                  
                  
                  2,298,446
                  
                  
                  
                  2,308,754




Pricing or valuation models are applied
using current market information to estimate fair value.  In some
cases, considerable judgment is required to interpret market data to develop the
estimates of fair value.  Accordingly, the estimates presented herein
are not necessarily indicative of the amounts the Company could realize in a
current market exchange.  The use of different market assumptions
and/or estimation methods may have a material effect on the estimated fair value
amounts.





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





Portions of this report contain
“forward-looking statements”, as that term is defined in the Private Securities
Litigation Reform Act of 1995.  Such forward-looking statements are
based on management’s expectations, estimates, projections and
assumptions.  These statements may be identified by the use of
forward-looking words or phrases such as “should”, “expects”, “anticipates”,
“plans”, “believes”, “estimates”, “might result”, “projects” and variations of
such words and similar expressions. These statements are not guarantees of
future performance and involve certain risks and uncertainties that are
difficult to predict.  Therefore, actual future results and trends may
differ materially from what is indicated in forward-looking statements due to a
variety of factors.  Such risks and uncertainties include liquidity
risks associated with our investor notes payable on demand by the holders, other
loans and short-term borrowings, delinquencies in our loan portfolio, capital
levels, changes in market interest rates, inability to generate new loans, and
competitive factors in our marketplace. These risks and uncertainties are
described in detail in the Company’s Annual Report on Form 10-K for the year
ended December 31, 2008.  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, KH Funding Company assumes no
obligation to update any forward looking statements even if experience or future
changes make it clear that projected results expressed or implied in such
statements will not be realized.





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





Recent
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.


-15-





Overview





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





Prior to 2007, our business activities
consisted of purchasing mortgage loans (80% of our business) and of originating,
acquiring and servicing mortgage loans (20% of our business).  Since
2007, our business activities have been limited to funding existing lines of
credit and draw-down loans and otherwise servicing our existing loan
portfolio.  To fund our operations and to satisfy our obligations
under our outstanding investor notes, including redemption requests, we have
traditionally relied on (i) funds received from loan pay-offs, (ii) interest and
other fee income received on our loans, and (iii) funds raised through the
issuance of interest-bearing debt securities to investors.  However,
we 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.  Although we are not currently able to publicly sell our
investor notes, we do have a signed selling agreement with a FINRA registered
broker-dealer with a network of over 400 registered representatives in the
Midwest and West.  In the past, 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.  If and when we are able to recommence our public offering
efforts, we plan to further increase our distribution network including in parts
of the United States where we are not currently represented.





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:


-16-





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





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





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





Assets.  Total
assets decreased by $2.48 million during the first nine months of 2009, from
$44.85 million at December 31, 2008 to $42.37 million at September 30,
2009.  The decrease was due to loan payoffs and increased allowance
for loan losses resulting in our loan portfolio decreasing by $2.89 million
ending at $33.97 million.





Liabilities.  Total
liabilities decreased by $1.39 million from $45.23 million at December 31,
2008 to $43.84 million at September 30, 2009.  The decrease was
primarily due to a reduction of $1.17 million in notes and accrued interest
payable and a reduction due to pay-downs of loans sold with recourse totaling
$0.93 million.  During the same period, collateralized notes payable
increased $0.62 million.





Deficit.  Total
stockholders’ deficit increased by $1.09 million from $(0.38) million at
December 31, 2008 to $(1.47) million  at September  30,
2009.  The increase was due to a net loss of $1.60 million offset by
the sale of 500,000 shares of common stock.





Past Due Loans.  As
of  September 30, 2009, we held 34 loans that were more than 90 days
past due but still accruing interest, compared to twenty-one as of December 31,
2008.  The total principal and interest due on these loans was $6.57
million compared to $10.01 million as of December 31,
2008.  Twenty-three of the loans, totaling $5.77 million, 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
eleven loans, totaling $0.80 million, are making scheduled payments, and we
continue to accrue interest on these loans based on the underlying collateral
values and payment histories.  We monitor these loans on a continuous
basis.





Non-Accrual
Loans.  As of September 30, 2009, there were 16 loans in
non-accrual status with an outstanding principal balance totaling $4.22 million,
compared to 20 loans as of December 31, 2008 with an outstanding principal
balance of $4.29 million.  The majority of these loans are first
mortgage loans that management believes are well-collateralized based on recent
valuations.  In the event we have to foreclose on any of these loans,
we do not expect to recognize any loss in excess of specific reserves associated
with the loans.  As of September 30, 2009, we had a specific reserve
of $496,515 and a general reserve of $369,633 as part of our total reserve of
$866,148 for anticipated and unanticipated loan losses.





Comparison
of Operating Results for Nine Months Ended September 30, 2009 and
2008





Net interest margin. The
average yield earned on loans receivable was 8.18% for the nine months ended
September 30, 2009 and 9.91% for the nine months ended September 30,
2008.  The average rate paid on investor notes decreased to 6.07% for
the nine months ended September 30, 2009 from 6.72% for the nine months ended
September 30, 2008.  Overall, the net margin on interest decreased to
2.11% for the nine months ended September 30, 2009, from 3.19% for the nine
months ended September 30, 2008.  This net margin is calculated using
contractual rates and excludes fee income and expense.





Net Loss.  Net loss
for the nine months ended September 30, 2009 was $1,598,281, compared to a net
loss of $474,844 for the nine months ended September 30, 2008.  The
difference was primarily due to a decrease in net interest income because many
higher-rate loans had been paid off in prior periods.


-17-





Interest
Income.  Total interest income was $2.36 million for the nine
months ended September 30, 2009, compared to $3.26 million for the same period
in 2008.  The decrease of $0.90 million in interest income was due to
a significant amount of our higher-rate loans having been paid off in prior
periods.  The decrease in interest earned on loans also resulted from
a decline in our loans receivable portfolio due to normal payoffs and a lack of
loan originations and purchases.  Interest income includes loan and
fee income and interest earned on bank investments and marketable
securities.





Interest
Expense.  Interest expense was $2.24 million for the nine
months ended September 30, 2009 and $2.68 million for the corresponding period
in 2008.  The decrease in interest expense for the 2009 period when
compared to the 2008 period was a result of a decrease in total investor notes
payable due to increased redemptions.  The interest expense includes
the amortization of fees paid to brokers-dealers in prior periods for the sale
of investor notes.





Provision for Loan
Losses.  Our provision for loan losses was $624,607 for the
nine months ended September 30, 2009, compared to $272,384 for the nine months
ended September 30, 2008.  These provisions increased the allowance
for loan losses to an amount deemed by management to be sufficient to meet all
anticipated loan losses plus a general amount to meet unforeseen loan
losses.  The adequacy of the allowance is periodically reviewed and
adjusted by management based upon past experience, the value of the underlying
collateral for specific loans, known or inherent risks in the loan portfolio and
current economic conditions.





Non-Interest (Loss)
Income.  We had a non-interest loss of $71,552 during the nine
months ended September 30, 2009, compared to income of $94,518 for the
corresponding period in 2008.  The difference was primarily due to
losses on the sale of other real estate owned totaling $156,991 offset by rental
income of $93,021 during the period ended September 30, 2009.





Non-Interest
Expense.  Non-interest expense increased to $1,028,678 for the
nine months ended September 30, 2009 from $875,187 for the nine months ended
September 30, 2008.  The increase was due to larger legal and
accounting fees that were incurred during the period ending September 30,
2009.





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




Comparison
of Operating Results for Three Months Ended September 30, 2009 and
2008




Net interest margin. The
average yield earned on loans receivable was 8.33% for the three months ended
September 30, 2009 and 9.68% for the three months ended September 30,
2008.  The average rate paid on investor notes decreased to 6.11% for
the three months ended September 30, 2009 from 6.59% for the three months ended
September 30, 2008, due primarily to the redemption of higher rate notes and a
decrease in the contractual rates we are required to pay on investor notes.
Overall, the net margin on interest decreased to 2.22% for the three months
ended September 30, 2009, from 3.09% for the three months ended September 30,
2008.  This net margin is calculated using contractual rates and
excludes fee income and expense.




Net Loss.  Net loss
for the three months ended September 30, 2009 was $666,789 compared to a net
loss of $181,941 for the three months ended September 30, 2008.  The
difference was primarily due to a decrease in net interest income because of a
decrease in interest earning assets and a reduced net margin together with an
increase in the provision for loan losses and also losses on the sale of other
real estate owned.




Interest
Income.  Total interest income was $754,710 for the three
months ended September 30, 2009, compared to $989,629 for the same period in
2008.  The decrease in interest income resulted from a decrease in
total loan portfolio due to loan payoffs and   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 $740,446 for the three months
ended September 30, 2009 and $835,993 for the corresponding period in
2008.  The decrease in interest expense was due to a reduction in
total investor notes payable due to redemptions.  The interest expense
includes the amortization of fees paid to Brokers-Dealers in prior periods for
the sale of investor notes.




Provision for Loan
Losses.  Our provision for loan losses was $271,569 for the
three months ended September 30, 2009 and $118,286 for the three months ended
September 30, 2008.  These provisions increased the allowance for loan
losses to an amount deemed by management to be sufficient to meet all
anticipated loan losses plus a general amount to meet unforeseen loan
losses.  The adequacy of the allowance is periodically reviewed and
adjusted by management based upon past experience, the value of the underlying
collateral for specific loans, known or inherent risks in the loan portfolio and
current economic conditions.


-18-




Non-Interest (Loss)
Income.  We had a non-interest loss of $144,928 during the
three months ended September 30, 2009, compared to  non-interest
income of $41,632 for the corresponding period in 2008.  The
difference was primarily due to the loss of $170,639 from the sale of other real
estate owned during the period ended September 30, 2009.




Non-Interest
Expense.  We experienced a slight increase in non-interest
expense to $264,536 for the three months ended September 30, 2009 from $258,923
for the three months ended September 30, 2008.  Decreases in salaries
and wages, bank charges and insurance were offset by increases in professional
fees, administration fees and real estate maintenance during the period ended
September 30, 2009.




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





Liquidity
and Capital Resources





At September 30, 2009, we had cash and
cash equivalents of $28,377, a historically low level, compared to $221,463 at
December 31, 2008 (0.49% of total assets) and $209,224 (0.43% of total assets)
at September 30, 2008.  During the first nine months of 2009, we
received approximately $2,695,283 in loan payments, which included unscheduled
prepayments and payments due at maturity, and we paid approximately $4,591,372
to redeem investor notes.  During the same period of 2008, we received
approximately $10,695,201 in loan payments, and we paid approximately
$13,352,867 to redeem investor notes.





For the nine months ended September 30,
2009, net cash provided by operating activities was $88,039, compared to
$2,050,397 that was provided by operating activities for the nine months ended
September 30, 2008.  The primary reasons for the decrease were a
$1,598,281 net loss for the period and an increase of $631,499 in interest
receivable on loans for the nine months ended September 30, 2009.





For the nine months ended September 30,
2009, net cash provided by investing activities was $2,829,722, compared to
$4,467,070 for the same period in 2008.  Cash provided by investing
activities for the nine months ended September 30, 2009 included $2,695,283 in
principal repayments on loans receivable offset by $623,533 in loans made to
borrowers, compared to $10,095,201 in principal repayments on loans receivable
and $6,093,811 in offsetting loans made to borrowers for the nine months ended
September 30, 2008.





For the nine months ended September 30,
2009, net cash used in financing activities was $3,110,847, compared to
$6,600,723 for the same period in 2008.  During the 2009 period, net
proceeds from the sale of collateralized note payables were $829,340, and
proceeds from the sale of investor notes were $1,587,775, while investor note
redemptions during the same periods totaled $0 and $1,397,180
respectively.





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.





Also, it
should be noted that loans are not always paid off at maturity. Having loans
with “short terms”, as we do, allows us to monitor a loan for deterioration in
collateral value and re-set the interest rate and term every year or two, and if
necessary obtain more collateral or call a loan instead of extending
it.  Often times, we collect extension fees, adjust the interest rate
and extend the loan.  If the loan is current and well collateralized
and the borrower wants to extend the loan, we will usually extend the
loan.


-19-


For
example, of the $23,863,597 in principal repayments that are due in 2009, the
following activity has occurred through September 30, 2009:





Principal
      received on loans due in 2009
                            
                            $
                            1,550,372Collection
      pending sale of collateral
                            
                            
                            579,724Collection
      pending third party refinancing
                            
                            
                            2,610,621Loans
      Extended
                            
                            
                            5,253,758Loans
      due After 9/30/09
                            
                            
                            11,537,090Unpaid
      as of 9/30/09
                            
                            
                            2,332,032Total
                            
                            $
                            23,863,597





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 September 30, 2009, we held
approximately $26.75 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.  Although, in the
current market, the price would probably be below par and instead, we are trying
to sell non-interest earning assets to satisfy pending investor redemption
requests.  These sales are discussed in more detail under “Recent
Developments” in the second paragraph of Item 2. Section I.Further, we held $1.30
million in second mortgage loans at September  30, 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 September
30, 2009, we were subject to redemption requests with respect to approximately
$0.23 million of outstanding investor notes that are within the 30-day grace
period for repayment and redemption requests of $3.67 million of outstanding
series 3 and series 4 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.  Included in the above amounts of outstanding note
redemptions, we are more than 30 days late in satisfying our payment obligations
with respect to approximately $1.76 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.


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The balances of our outstanding
investor notes at September 30, 2009 are as follows:





Series
      3 Demand Notes
                      
                      BalanceOne
      Day
                      
                      $
                      5,593,202Thirty
      Day
                      
                      
                      9,930,873Series
      3 Fixed Term Notes:Due
      within 1 year
                      
                      
                      8,325,165Due
      in 1 to 3 years
                      
                      
                      5,647,879Due
      in 3 to 5 years
                      
                      
                      5,703,162Series
      4 Fixed Term Notes:Due
      within 1 year
                      
                      
                      943,942Due
      in 1 to 3 years
                      
                      
                      338,663Due
      in 3 to 5 years
                      
                      
                      1,214,518Subtotal
                      
                      
                      37,658,594Unamortized
      brokerage costs
                      
                      
                      (38,807
                      )Total
      investor notes, net
                      
                      $
                      37,697,401





To
address the Company’s immediate liquidity needs, it is aggressively marketing
its Other Real Estate Owned held for sale, which had a carrying value of about
$3.67 million at September 30, 2009, and has already listed for sale about $3.57
million of these properties. The Company is also aggressively pursuing the
collection of $4.22 million in impaired loans on its books at September 30,
2009. Through these efforts, the Company hopes to raise cash to fund operations,
including satisfying investor note redemption requests, and to provide the cash
needed to renew our investor note offering efforts. There can be no assurance,
however, as to when or if we will be successful in raising cash from the sale of
these assets or renewing our public offering efforts. Moreover, even if our
public offering efforts are renewed, 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.





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 a deficit of (3.47%) at September
30, 2009. During the period ending September 30, 2009, we experienced an
operating loss of $1,598,281 combined with stock sales of $500,000 resulting in
an ending stockholders deficit of $1,468,644. Our Board suspended the payment of
stock dividends after the second quarter of 2007 to help maintain sufficient
equity levels.





Sub-Prime Loans and Lending.
Recently, the sub-prime mortgage lending environment has experienced
considerable strain from rising delinquencies and liquidity pressures. Several
high profile sub-prime mortgage lenders have failed, and these failures have
adversely impacted the financial markets and economy in general. These market
conditions have resulted in increased scrutiny of sub-prime lending practices.
Although we make and acquire loans that may be considered “sub-prime loans”, we
believe that our exposure to problems in the industry is limited as a result of
several factors. First, at September 30, 2009 our sub-prime loans amounted to
only $2.37 million, or 7.84% 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.


-21-





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 September 30, 2009 was carried out under the
supervision and with the participation of Management, including the
CEO.  Based on that evaluation, the Company’s management, including
the CEO, has concluded that our disclosure controls and procedures are, in fact,
effective at the reasonable assurance level.





During the third quarter of 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 filed 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.  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.  In
fact, the information we have obtained to date lead us to believe that no
wrongdoing took place and that Ms. Ghadry authorized any and all actions taken
by Mr. Angeli on her behalf or for her account, which, if they occurred, were
conducted outside the scope of his employment with us.  Ms. Ghadry’s
claims against us include breach of contract, fraud, breach of fiduciary duty,
conversion, negligent supervision, negligence, re-credit of account for
unauthorized transfers, aiding and abetting conversion, aiding and abetting
fraud, and aiding and abetting breach of fiduciary duty.  Ms. Ghadry
seeks compensatory damages from us in the amount of $864,298.20 and punitive
damages from us in the amount of $5.0 million, plus costs and
interest.  We believe that we have strong defenses to these claims and
intend to vigorously defend this lawsuit, although we cannot predict the outcome
of this litigation or its financial impact on us.  We have insurance
policies in place that we believe would provide coverage for up to $3.0 million,
but there can be no assurance that our policies will cover any or all of these
claims.





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


-22-





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 and in Item 1A of Part II of our Quarterly
Report on Form 10-Q for the quarter ended June 30, 2009.





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.





SIGNATURES





Pursuant to the requirements of the
Securities Exchange Act of 1934, the registrant has duly causedthis report to be signed
on its behalf by the undersigned thereunto duly authorized.





KH
      FUNDING COMPANYDate:  November
      16, 2009
              By:
              /s/ Robert L. HarrisRobert
      L. HarrisPresident,
      Chief Executive Officer,and
      Acting Chief Financial Officer




-23-


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).


-24-