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 June 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








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 £





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 o No x





APPLICABLE
ONLY TO CORPORATE ISSUERS





Indicate
the number of shares outstanding of each of the issuer’s classes of common
stock, as of the latest practicable date:  3,074,981 shares, par value
$.01 per share, of common stock outstanding as of June 30,
2009.





INDEX





PagePart
      I.  Financial Information
                        3Item
      1.  Financial Statements
                        3Balance
      Sheets -June
      30, 2009 (unaudited) and December 31, 2008
                        3Statements
      of Operations (unaudited) -For
      the three and six months ended June 30, 2009 and 2008
                        4Statements
      of Changes in Stockholders’ Deficit (unaudited) -For
      the six months ended June 30, 2009 and 2008
                        5Statements
      of Cash Flows (unaudited) -For
      the six months ended June 30, 2009 and 2008
                        6Notes
      to Interim Financial Statements (unaudited)
                        7Item
      2.  Management’s Discussion and Analysis of Financial Condition
      and Results of Operations
                        14Item
      4.  Controls and Procedures
                        19Part
      II.  Other Information
                        20Item
      1.  Legal Proceedings
                        20Item
      1A.  Risk Factors
                        20Item
      3.  Defaults Upon Senior Securities
                        21Item
      6.  Exhibits
                        21Signatures
                        21Exhibit
      Index
                        22


-2-


PART
I – FINANCIAL INFORMATION





Item
1.  Financial Statements.





KH
FUNDING COMPANY


BALANCE
SHEETS





June
      30,
                      2009
                    
                    
                    December
      31,
                      2008(unaudited)AssetsCash
                    
                    $
                    1,697
                    
                    
                    $
                    221,463Loans
      receivable, less allowance for loan losses of $743,565 (June 30, 2009) and
      $659,242 (December 31, 2008)
                    
                    
                    35,883,895
                    
                    
                    
                    36,860,118Accrued
      interest receivable
                    
                    
                    2,179,516
                    
                    
                    
                    2,155,100Other
      receivables
                    
                    
                    403,880
                    
                    
                    
                    542,718Prepaid
      expenses
                    
                    
                    191,053
                    
                    
                    
                    219,458Property
      and equipment – net
                    
                    
                    61,993
                    
                    
                    
                    101,070Real
      estate owned:Rental
      property
                    
                    
                    1,910,769
                    
                    
                    
                    2,079,374Held
      for sale
                    
                    
                    4,590,110
                    
                    
                    
                    2,652,069Other
      assets
                    
                    
                    15,988
                    
                    
                    
                    15,988Total
      Assets
                    
                    $
                    45,238,901
                    
                    
                    $
                    44,847,358Liabilities
      and Stockholders’ DeficitLiabilitiesNotes
      and accrued interest payable
                    
                    $
                    38,648,499
                    
                    
                    $
                    38,828,923Other
      loans payable
                    
                    
                    24,942
                    
                    
                    
                    92,408Accounts
      payable and accrued expenses
                    
                    
                    295,670
                    
                    
                    
                    42,705Escrows
      and security deposits
                    
                    
                    82,234
                    
                    
                    
                    81,115Long-term
      liabilities
                    
                    
                    49,566
                    
                    
                    
                    50,857Loans
      sold with recourse
                    
                    
                    4,426,795
                    
                    
                    
                    4,454,698Collateralized
      notes payable
                    
                    
                    2,513,051
                    
                    
                    
                    1,678,782Total
      Liabilities
                    
                    
                    46,040,757
                    
                    
                    
                    45,229,488Stockholders’
      DeficitCommon
      stock (5,000,000 shares authorized; 3,074,981 shares (June 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
                    
                    
                    (2,602,661
                    )
                    
                    
                    (1,671,168
                    )Subscription
      note receivable
                    
                    
                    (185,450
                    )
                    
                    
                    (185,450
                    )Total
      Stockholders’ Deficit
                    
                    
                    (801,856
                    )
                    
                    
                    (382,130
                    )Total
      Liabilities and Stockholders’ Deficit
                    
                    $
                    45,238,901
                    
                    
                    $
                    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 June 30,
                                                        
                                                        
                                                        For the Six
                                                          Months
                                                          Ended June 30,2009
                                                        
                                                        
                                                        2008
                                                        
                                                        
                                                        2009
                                                        
                                                        
                                                        2008Interest
      IncomeInterest
      and fees on loans
                                                        
                                                        $
                                                        795,211
                                                        
                                                        
                                                        $
                                                        1,052,310
                                                        
                                                        
                                                        $
                                                        1,607,078
                                                        
                                                        
                                                        $
                                                        2,266,447Interest
      on bank accounts
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        33
                                                        
                                                        
                                                        
                                                        2
                                                        
                                                        
                                                        
                                                        78Total
      interest income
                                                        
                                                        
                                                        795,211
                                                        
                                                        
                                                        
                                                        1,052,343
                                                        
                                                        
                                                        
                                                        1,607,080
                                                        
                                                        
                                                        
                                                        2,266,525Interest
      ExpenseInterest
      and fees on notes
                                                        
                                                        
                                                        623,057
                                                        
                                                        
                                                        
                                                        754,139
                                                        
                                                        
                                                        
                                                        1,220,152
                                                        
                                                        
                                                        
                                                        1,623,916Interest
      on other loans
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        14,740
                                                        
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        106,375Interest
      on collateralized notes payable and loans sold with
    recourse
                                                        
                                                        
                                                        137,515
                                                        
                                                        
                                                        
                                                        103,593
                                                        
                                                        
                                                        
                                                        274,656
                                                        
                                                        
                                                        
                                                        111,661Total
      interest expense
                                                        
                                                        
                                                        760,572
                                                        
                                                        
                                                        
                                                        872,472
                                                        
                                                        
                                                        
                                                        1,494,808
                                                        
                                                        
                                                        
                                                        1,841,952Net
      interest income
                                                        
                                                        
                                                        34,639
                                                        
                                                        
                                                        
                                                        179,871
                                                        
                                                        
                                                        
                                                        112,272
                                                        
                                                        
                                                        
                                                        424,573Provision
      for Loan Losses
                                                        
                                                        
                                                        319,310
                                                        
                                                        
                                                        
                                                        75,000
                                                        
                                                        
                                                        
                                                        353,038
                                                        
                                                        
                                                        
                                                        154,098Net
      Interest (Expense) Income after Provision for Loan Losses
                                                        
                                                        
                                                        (284,671
                                                        )
                                                        
                                                        
                                                        104,871
                                                        
                                                        
                                                        
                                                        (240,766
                                                        )
                                                        
                                                        
                                                        270,475Non-interest
      IncomeRental
      income
                                                        
                                                        
                                                        37,373
                                                        
                                                        
                                                        
                                                        26,613
                                                        
                                                        
                                                        
                                                        69,575
                                                        
                                                        
                                                        
                                                        49,043Gain
      (loss) on sale of real estate owned
                                                        
                                                        
                                                        13,648
                                                        
                                                        
                                                        
                                                        (4,732
                                                        )
                                                        
                                                        
                                                        13,648
                                                        
                                                        
                                                        
                                                        (4,472
                                                        )Loss
      on the sale of property and equipment
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        (10,906
                                                        )
                                                        
                                                        
                                                        -Other
                                                        
                                                        
                                                        219
                                                        
                                                        
                                                        
                                                        1,336
                                                        
                                                        
                                                        
                                                        1,099
                                                        
                                                        
                                                        
                                                        8,575Total
      non-interest income
                                                        
                                                        
                                                        51,240
                                                        
                                                        
                                                        
                                                        23,217
                                                        
                                                        
                                                        
                                                        73,416
                                                        
                                                        
                                                        
                                                        52,886Non-interest
      ExpenseSalaries
      and wages
                                                        
                                                        
                                                        84,247
                                                        
                                                        
                                                        
                                                        81,559
                                                        
                                                        
                                                        
                                                        162,328
                                                        
                                                        
                                                        
                                                        168,436Professional
      fees
                                                        
                                                        
                                                        119,695
                                                        
                                                        
                                                        
                                                        54,573
                                                        
                                                        
                                                        
                                                        268,301
                                                        
                                                        
                                                        
                                                        104,532Offering
      costs
                                                        
                                                        
                                                        30,282
                                                        
                                                        
                                                        
                                                        39,423
                                                        
                                                        
                                                        
                                                        78,604
                                                        
                                                        
                                                        
                                                        72,203Administration
                                                        
                                                        
                                                        12,794
                                                        
                                                        
                                                        
                                                        32,971
                                                        
                                                        
                                                        
                                                        24,950
                                                        
                                                        
                                                        
                                                        49,674Real
      estate maintenance
                                                        
                                                        
                                                        20,414
                                                        
                                                        
                                                        
                                                        34,206
                                                        
                                                        
                                                        
                                                        62,712
                                                        
                                                        
                                                        
                                                        55,378Insurance
                                                        
                                                        
                                                        15,180
                                                        
                                                        
                                                        
                                                        21,526
                                                        
                                                        
                                                        
                                                        28,224
                                                        
                                                        
                                                        
                                                        38,631Depreciation
                                                        
                                                        
                                                        18,627
                                                        
                                                        
                                                        
                                                        14,709
                                                        
                                                        
                                                        
                                                        36,614
                                                        
                                                        
                                                        
                                                        30,339Rent
                                                        
                                                        
                                                        28,399
                                                        
                                                        
                                                        
                                                        28,097
                                                        
                                                        
                                                        
                                                        59,603
                                                        
                                                        
                                                        
                                                        57,916Bank
      charges
                                                        
                                                        
                                                        10,685
                                                        
                                                        
                                                        
                                                        13,038
                                                        
                                                        
                                                        
                                                        23,657
                                                        
                                                        
                                                        
                                                        26,793Stock
      based compensation
                                                        
                                                        
                                                        7,498
                                                        
                                                        
                                                        
                                                        4,268
                                                        
                                                        
                                                        
                                                        11,767
                                                        
                                                        
                                                        
                                                        7,792Other
                                                        
                                                        
                                                        2,127
                                                        
                                                        
                                                        
                                                        1,698
                                                        
                                                        
                                                        
                                                        7,383
                                                        
                                                        
                                                        
                                                        4,570Total
      non-interest expense
                                                        
                                                        
                                                        349,948
                                                        
                                                        
                                                        
                                                        326,068
                                                        
                                                        
                                                        
                                                        764,143
                                                        
                                                        
                                                        
                                                        616,264Net
      Loss
                                                        
                                                        $
                                                        (583,379
                                                        )
                                                        
                                                        $
                                                        (197,980
                                                        )
                                                        
                                                        $
                                                        (931,493
                                                        )
                                                        
                                                        $
                                                        (292,903
                                                        )Basic
      and diluted loss per share
                                                        
                                                        $
                                                        (0.19
                                                        )
                                                        
                                                        $
                                                        (0.08
                                                        )
                                                        
                                                        $
                                                        (0.31
                                                        )
                                                        
                                                        $
                                                        (0.11
                                                        )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 SIX MONTHS ENDED JUNE 30, 2009 and 2008





Common
      Stock
                      
                      
                      
                      
                      
                      
                      
                      
                      Subscription
                      
                      
                      Total
                        Stockholders’Shares
                      
                      
                      Amount
                      
                      
                      Paid-In
                        Capital
                      
                      
                      Accumulated
                        Deficit
                      
                      
                      Note
                        Receivable
                      
                      
                      Equity
                        (Deficit)Balances
      at January 1, 2008
                      
                      
                      2,724,981
                      
                      
                      $
                      27,250
                      
                      
                      $
                      1,730,911
                      
                      
                      $
                      (533,645
                      )
                      
                      $
                      (185,450
                      )
                      
                      $
                      1,039,066Stock
      Redemptions
                      
                      
                      (150,000
                      )
                      
                      
                      (1,500
                      )
                      
                      
                      (298,500
                      )
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      (300,000
                      )Stock
      Based Compensation Expense
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      7,792
                      
                      
                      
                      –
                      
                      
                      
                      –
                      
                      
                      
                      7,792Net
      loss for period ended June 30, 2008
                      
                      
                      –
                      
                      
                      
                      –
                      
                      
                      
                      –
                      
                      
                      
                      (292,903
                      )
                      
                      
                      –
                      
                      
                      
                      (292,903
                      )Balances
      at June 30, 2008
                      
                      
                      2,574,981
                      
                      
                      $
                      25,750
                      
                      
                      $
                      1,440,203
                      
                      
                      $
                      (826,548
                      )
                      
                      $
                      (185,450
                      )
                      
                      $
                      453,955Balances
      at January 1, 2009
                      
                      
                      2,574,981
                      
                      
                      $
                      25,750
                      
                      
                      $
                      1,448,738
                      
                      
                      $
                      (1,671,168
                      )
                      
                      $
                      (185,450
                      )
                      
                      $
                      (382,130
                      )Stock
      Issued
                      
                      
                      500,000
                      
                      
                      
                      5,000
                      
                      
                      
                      495,000
                      
                      
                      
                      –
                      
                      
                      
                      –
                      
                      
                      
                      500,000Stock
      Based Compensation Expense
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      11,767
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      11,767Net
      loss for period ended June 30, 2009
                      
                      
                      –
                      
                      
                      
                      –
                      
                      
                      
                      –
                      
                      
                      
                      (931,493
                      )
                      
                      
                      –
                      
                      
                      
                      (931,493
                      )Balances
      at June 30, 2009
                      
                      
                      3,074,981
                      
                      
                      $
                      30,750
                      
                      
                      $
                      1,955,505
                      
                      
                      $
                      (2,602,661
                      )
                      
                      $
                      (185,450
                      )
                      
                      $
                      (801,856
                      )





The
accompanying notes are an integral part of these statements.


-5-


KH
FUNDING COMPANY


STATEMENTS
OF CASH FLOWS (UNAUDITED)





For
      the six months ended June 30,2009
                      
                      
                      
                      2008Cash
      from Operating ActivitiesNet
      loss
                      $
                      (931,493
                      )
                      
                      $
                      (292,903
                      )Adjustments
      to Reconcile Net Loss to Net Cash from Operating
    Activities:Depreciation
                      
                      36,614
                      
                      
                      
                      30,339Amortization
      of loan fees
                      
                      (10,992
                      )
                      
                      
                      (14,608
                      )Provision
      for loan losses
                      
                      353,038
                      
                      
                      
                      154,098(Gain)
      loss on sale of real estate owned
                      
                      (13,648
                      )
                      
                      
                      4,732Loss
      on sale of property and equipment
                      
                      10,906
                      
                      
                      
                      -Stock
      based compensation expense
                      
                      11,767
                      
                      
                      
                      7,792Changes
      in Operating Assets and LiabilitiesAccrued
      late charges
                      
                      (69,718
                      )
                      
                      
                      (10,257
                      )Prepaid
      expenses
                      
                      10,502
                      
                      
                      
                      22,676Accrued
      interest receivable
                      
                      (579,241
                      )
                      
                      
                      1,073,347Interest
      payable (included in notes payable)
                      
                      718,955
                      
                      
                      
                      1,016,912Accounts
      payable and accrued expenses
                      
                      252,965
                      
                      
                      
                      95Prepaid
      offering costs
                      
                      17,903
                      
                      
                      
                      (5,108
                      )Deferred
      loan origination costs
                      
                      6,000
                      
                      
                      
                      6,900Unamortized
      brokerage fees
                      
                      23,808
                      
                      
                      
                      32,750Long
      term lease liability
                      
                      (1,291
                      )
                      
                      
                      5,257Prepaid
      loan expenses
                      
                      51,000
                      
                      
                      
                      51,297Net
      Cash (Used in) Provided by Operating Activities
                      
                      (112,925
                      )
                      
                      
                      2,083,319Cash
      Flows from Investing ActivitiesPrincipal
      repayments from borrowers
                      
                      772,538
                      
                      
                      
                      9,291,650Loans
      made to borrowers
                      
                      (356,462
                      )
                      
                      
                      (5,199,922
                      )Receivable
      for participation loan
                      
                      -
                      
                      
                      
                      (451,000
                      )Net
      other receivable
                      
                      (106,403
                      )
                      
                      
                      (52,785
                      )Proceeds
      from sale of property and equipment
                      
                      10,000
                      
                      
                      
                      -Proceeds
      from sale of real estate owned
                      
                      64,589
                      
                      
                      
                      16,151Payments
      on other real estate owned
                      
                      (2,649
                      )
                      
                      
                      (12,810
                      )Net
      Cash Provided by Investing Activities
                      
                      381,613
                      
                      
                      
                      3,591,284Cash
      Flows from Financing ActivitiesProceeds
      from investor notes
                      
                      1,504,267
                      
                      
                      
                      980,692Principal
      payments on investor notes
                      
                      (3,026,712
                      )
                      
                      
                      (11,191,349
                      )Proceeds
      from loans sold with recourse
                      
                      -
                      
                      
                      
                      4,438,611Principal
      payments on loans sold with recourse
                      
                      (27,903
                      )
                      
                      
                      -Proceeds
      from collateralized notes payable
                      
                      1,043,945
                      
                      
                      
                      -Other
      loans payable
                      
                      24,942
                      
                      
                      
                      493,331Redemption
      of common stock
                      
                      -
                      
                      
                      
                      (300,000
                      )(Increase)
      decrease in escrows and security deposits
                      
                      (6,993
                      )
                      
                      
                      17,714Net
      Cash Used in Financing Activities
                      
                      (488,454
                      )
                      
                      
                      (5,561,001
                      )Net
      (Decrease) Increase in Cash
                      
                      (219,766
                      )
                      
                      
                      113,602Cash
      Balance, beginning of period
                      
                      221,463
                      
                      
                      
                      95,622Cash
      Balance, end of period
                      $
                      1,697
                      
                      
                      $
                      209,224Supplemental
      Cash Flow Information:Interest
      paid
                      $
                      440,695
                      
                      
                      $
                      825,040Transfer
      of loans to real estate owned
                      $
                      750,252
                      
                      
                      $
                      1,031,280


The
accompanying notes are an integral part of these statements.


-6-


KH
Funding Company


Notes to
Interim Financial Statements


For the
Six Months Ended June, 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 June 30, 2009, the results of
operations for the three- and six-month periods ended June 30, 2009 and 2008,
changes in stockholders’ (deficit) equity for the six-month periods ended June
30, 2009 and 2008, and cash flows for the six-month periods ended June 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 six-month periods ended June 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.  Further, in connection with preparation of the
financial statements and in accordance with the recently issued Statement of
Financial Accounting Standards No. 165 “Subsequent Events” (“SFAS 165”), the
Company evaluated subsequent events after the balance sheet date through August
13, 2009.   No significant subsequent events were identified
which would affect the presentation of the financial information.





The financial statements contemplate
continuation of the Company as a going concern.  As discussed in Note
B to the audited financial statements presented in the Company’s Annual Report
on Form 10-K for the year ended December 31, 2008, the Company experienced
significant delays starting in the second quarter of 2006 in obtaining an
effective registration statement covering the offer and sale of its investor
notes.  The Company’s most recent registration statement, covering the
offer and sale of an aggregate of $250 million of 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 but expired on April 30, 2009.  Accordingly, the Company
enjoyed only a limited period during the last three years during which it was
able to publicly offer and sell its investor notes and raise funds for
operations.  As a result, there is a significant risk that the Company
may have difficulty meeting its future liquidity needs.  The Company
requires cash to make and acquire loans, redeem outstanding investor notes, and
pay other operational expenses.  Although the Company anticipates that
it will continue to receive unscheduled and scheduled loan payments on a
going-forward basis, it is doubtful that these funds, alone, can meet the
Company’s cash needs.  The Company intends to take steps necessary to
update its most recent offering prospectus and recommence its offering efforts,
but there can be no assurance as to when, if at all, this will
happen.  Additionally, stockholders’ deficit at June 30, 2009 has
increased to (1.76%) of total assets, which the Company believes to be
inadequate to fully protect it against potential losses.  Accordingly,
because both future income from loans and cash needed for operations, including
investor note redemptions, are uncertain and because the Company cannot predict
if or when it will recommence offering its investor notes to the public, there
is substantial doubt about the Company’s ability to continue as a going
concern.





NOTE
B—SIGNIFICANT ACCOUNTING POLICIES AND RECENT ACCOUNTING
PRONOUNCEMENTS





Significant
Accounting Policies and Estimates





Note A to the audited financial
statements contained in the Company’s Annual Report on Form 10-K for the year
ended December 31, 2008 describes the significant accounting policies used in
the preparation of the Company’s financial statements.





Nature
of Operations





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





Use
of Estimates in Preparing Financial Statements





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


-7-


Loss
Per Share





Basic loss per share is computed by
dividing net losses incurred by the Company by the weighted-average number of
common shares outstanding.  Diluted loss per share is computed after
adjusting the denominator of the basic loss per share computation for the
effects of all dilutive potential common shares outstanding during the
period.  As of June 30, 2009 and June 30, 2008, the Company had
outstanding stock options to purchase 241,250 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
                          June
      30,
                        
                        
                        For
      The Six
                          Months
      Ended
                          June
      30,2009
                        
                        
                        2008
                        
                        
                        2009
                        
                        
                        2008(unaudited)
                        
                        
                        (unaudited)Basic:Net
      loss (attributable to common stock)
                        
                        $
                        (583,379
                        )
                        
                        $
                        (197,980
                        )
                        
                        $
                        (931,493
                        )
                        
                        $
                        (292,903
                        )Weighted
      average common shares outstanding
                        
                        
                        3,074,981
                        
                        
                        
                        2,574,981
                        
                        
                        
                        3,014,208
                        
                        
                        
                        2,574,981Basic
      loss per share
                        
                        $
                        (0.19
                        )
                        
                        $
                        (0.08
                        )
                        
                        $
                        (0.31
                        )
                        
                        $
                        (0.11
                        )Diluted:Net
      loss (attributable to common stock)
                        
                        $
                        (583,379
                        )
                        
                        $
                        (197,980
                        )
                        
                        $
                        (931,493
                        )
                        
                        $
                        (292,903
                        )Weighted
      average common shares outstanding
                        
                        
                        3,074,981
                        
                        
                        
                        2,574,981
                        
                        
                        
                        3,014,208
                        
                        
                        
                        2,574,981Dilutive
      effect of stock options
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -Weighted
      average common shares outstanding-diluted
                        
                        
                        3,074,981
                        
                        
                        
                        2,574,981
                        
                        
                        
                        3,014,208
                        
                        
                        
                        2,574,981Diluted
      loss per share
                        
                        $
                        (0.19
                        )
                        
                        $
                        (0.08
                        )
                        
                        $
                        (0.31
                        )
                        
                        $
                        (0.11
                        )





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 2008, the Financial Accounting
Standards Board (“FASB”) issued FASB Staff Position (“FSP”) No. APB 14-1,
Accounting for Convertible
Debt Instruments That May Be Settled in Cash Upon Conversion (Including Partial
Cash Settlement) (“FSP APB 14-1”). Under the new rules for
convertible debt instruments that may be settled entirely or partially in cash
upon conversion, an entity should separately account for the liability and
equity components of the instrument in a manner that reflects the issuer's
economic interest cost.  FSP APB 14-1 will be effective for
fiscal years beginning after December 15, 2008, and for interim periods
within those fiscal years, with retrospective application required. Early
adoption is not permitted. As of the date of these financial statements, the
Company does not have any instruments outstanding that would be subject to FSP
APB 14-1, but any instruments that it may issue in the future will be
subject to this pronouncement.





In May 2008, FASB issued Statement of
Financial Accounting Standards (“SFAS”) 162, “The Hierarchy of Generally
Accepted Accounting
Principles”.  SFAS 162 identifies the sources of
accounting principles and the framework for selecting the principles used in the
preparation of financial statements. SFAS 162 was effective
November 15, 2008. The adoption of SFAS 162 did not have a material
impact on the Company’s financial position, results of operations or cash
flows.





In June 2008, the FASB ratified
Emerging Issue Task Force (EITF) Issue No. 07-5, “Determining Whether an
Instrument (or an
Embedded Feature) is Indexed to an Entity's Own Stock " (EITF 07-5).
This issue provides guidance for determining whether an equity-linked financial
instrument (or embedded feature) is indexed to an entity's own
stock.  EITF 07-5 is effective for fiscal years beginning after
December 15, 2008.  The Company has concluded that application of
EITF 07-5 does not have a material impact on the Company’s financial
statements.





In May 2009, the FASB issued SFAS
165, “Subsequent
Events.” SFAS 165 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.  SFAS 165 is effective for financial statements issued for
interim or annual periods ending after June 15, 2009. The implementation of SFAS
165 did not have a material impact on our financial statements.  The
Company has included the information required by this standard in Note
1.


-8-


In June 2009, the FASB issued SFAS
168 “The FASB Accounting
Standards Codification and the Hierarchy of Generally Accepted Accounting
Principles” a replacement of SFAS 162.  SFAS 168 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 SFAS
168, 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.  SFAS
168 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 SFAS 162.





In June 2009, the FASB issued SFAS
167, “Amendments to FASB
Interpretation No. 46(R)”.  The Board’s
objective in issuing SFAS 167 is to improve financial reporting by enterprises
involved with variable interest entities. SFAS 167 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 SFAS 167 will have a material impact on the Company’s financial
statements.





In June 2009, the FASB issued SFAS
166, “Accounting for Transfers
of Financial Assets—an amendment of FASB Statement No.
140”.  The Board’s objective in issuing SFAS 166 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.  SFAS 166 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 SFAS 166 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.





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


-9-


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





June
      30,
                    2009
                  
                  
                  December
      31,
                    2008(unaudited)Total
      recorded investment in impaired loans
                  
                  $
                  4,248,063
                  
                  
                  $
                  4,043,791Amount
      of that recorded investment for which there is a related allowance for
      loan losses
                  
                  $
                  2,742,015
                  
                  
                  $
                  1,691,398Amount
      of related allowance for loan losses associated with such
      investment
                  
                  $
                  527,933
                  
                  
                  $
                  448,298Amount
      of that recorded investment for which there is no related allowance for
      loan losses
                  
                  $
                  1,506,048
                  
                  
                  $
                  2,352,393





For
      the six months
                    ended
      June 30,
                    2009
                  
                  
                  For
      the year ended
                    December
      31,
                    2008(unaudited)Average
      recorded investment in impaired loans during period
                  
                  $
                  4,145,927
                  
                  
                  $
                  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 June 30, 2009 and December 31, 2008,
the Company had loans of $11,580,208 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 six months
                      ended June 30,
                      2009
                    
                    
                    For the six months
                      ended June 30,
                      2008(unaudited)
                    
                    
                    (unaudited)Beginning
      balance
                    
                    $
                    659,297
                    
                    
                    $
                    495,480Provision
      for loan losses
                    
                    
                    435,085
                    
                    
                    
                    154,098Loans
      charged off
                    
                    
                    (350,817
                    )
                    
                    
                    (57,454
                    )Ending
      balance
                    
                    $
                    743,565
                    
                    
                    $
                    592,124





NOTE
D—RELATED PARTY TRANSACTIONS





Included in notes receivable at June
30, 2009 and December 31, 2008, are 12 notes totaling $11,124,942 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%. The majority (94.2%) of these notes receivable were due from one
stockholder and its related interests, who owed $10,482,557 as of June 30,
2009.





Included
in the notes receivable at June 30, 2009 and December 31, 2008 are six loans in
the amount of $10.48 million and $10.19 million, respectively, to a trust for
the benefit of a significant stockholder.  The proceeds of these loans
were used to purchase real estate which serves as security for the
loans.  The Company holds a first or second lien position with respect
to the collateral securing approximately $9.75 million of these loans as well as
other real and personal collateral for June 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 June 30, 2009 and
December 31, 2008, are 53 notes totaling $6,747,330 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.


-10-


There is an interest-only demand note
receivable of $185,450 included in other receivables, shown on the balance sheet
at June 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 secure the
loan.  The interest rate on this loan is 7%.  At June 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.





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 persons unrelated to the Company.





During the six months ended June 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 six months ended June 30, 2009 or 2008.  The Company accrues
related compensation expenses as its options vest in accordance with SFAS
123(R), “Share-Based
Payment”.  The Company recognized stock-based compensation
expense of $11,767 and $7,792 during the six months ended June 30, 2009 and
2008, respectively, from the vesting of stock options issued in earlier
periods.  Stock-based compensation does not include any expense
related to stock or stock options granted to directors as no such grants were
awarded or earned during the six months ended June 30, 2009 and
2008.





A summary of stock option activity
during the six months ended June 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
                  
                  
                  –
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  -Outstanding
      at June 30, 2009
                  
                  
                  241,250
                  
                  
                  
                  2.39
                  
                  
                  
                  0.84
                  
                  
                  
                  -Exercisable
      at June 30, 2009
                  
                  
                  241,250
                  
                  
                  
                  2.29
                  
                  
                  
                  0.69
                  
                  
                  
                  -





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





NOTE
F—COMMITMENTS AND CONTINGENT LIABILITIES





Off-Balance
Sheet Arrangements




The Company enters into off-balance
sheet arrangements in the normal course of its business. These arrangements
consist primarily of lines-of-credit and draw-type loans. At June 30, 2009, the
Company had $4.88 million in loans of this type.  The unused or
unfunded amount on these types of loans totaled $0.84 million as of June 30,
2009.


-11-


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 June 30, 2009:





Interest
                    rate
                  
                  Due Date
                  
                  Amount Owed
                  
                  Payment Terms10.00
                  %
                  6/1/2009
                  
                  $
                  207,000
                  
                  Balance
      at 3/31/09 $200,000 with monthly interest only payments due 1st
      of each month.10.00
                  %
                  6/1/2009
                  
                  
                  207,000
                  
                  Interest
      only payments due 1st
      of each month.10.00
                  %
                  6/1/2009
                  
                  
                  205,086
                  
                  Interest
      only payments due 1st
      of each month.8.00
                  %
                  9/4/2009
                  
                  
                  100,000
                  
                  Interest
      only payments due 1st
      of each month.10.00
                  %
                  12/31/2009
                  
                  
                  200,000
                  
                  Interest
      only payments due monthly.10.00
                  %
                  12/31/2009
                  
                  
                  125,000
                  
                  Interest
      only payments due monthly.10.00
                  %
                  12/31/2009
                  
                  
                  200,000
                  
                  Interest
      only payments due monthly.7.5
                  %
                  3/1/2010
                  
                  
                  488,000
                  
                  Monthly
      payment of $6,000 principal plus interest earned7.5
                  %
                  6/25/2010
                  
                  
                  200,000
                  
                  Interest
      accrued with principal curtailments as requested7.5
                  %
                  1/31/2010
                  
                  
                  580,965
                  
                  Interest
      accrued with principal curtailments as requestedTotal
      Collateralized Notes Payable
                  
                  
                  
                  
                  
                  
                  $
                  2,513,051





NOTE
H— LOAN PARTICIPATIONS SOLD WITH RECOURSE





From time
to time, the Company sells participation interests 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 period ended June 30, 2008,
the Company entered into two such participation agreements and received a total
of $2.99 million and paid down one existing participation agreement in the
amount of $8,464.  During the period ended June 30, 2009, the Company
paid down its existing agreements in the amount of $27,903 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 monthly12.50
                        %
                        6/1/2010
                        
                        
                        889,000
                        
                        Interest
      only payment monthly9.04
                        %
                        1/1/2011
                        
                        
                        2,492,929
                        
                        Interest
      and principal payment monthly10.00
                        %
                        1/1/2011
                        
                        
                        390,102
                        
                        Interest
      and principal payment monthlyTotal
      Loans Sold with Recourse
                        
                        
                        
                        $
                        4,426,795





On October 24, 2007, the Company sold a
loan participation with recourse, in the amount of $261,764, which was to be
repaid upon the earlier of October 24, 2008 or the date of the collection of the
loan.  The loan has not been fully repaid and the Company and the
participant are working together to collect on the loan and satisfy the
Company’s obligations to the participant.  The Company has recorded a
$203,764 liability on its books as of June 30, 2009 related to this
obligation.


-12-


NOTE  I—FAIR
VALUE MEASUREMENTS




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





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







Impaired
Loans




The
Company does not record loans at fair value on a recurring basis however, from
time to time, a loan is considered impaired and an allowance for loan loss is
established.  Loans for which it is probable that payment of interest
and 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 SFAS
114, “Accounting by Creditors
for Impairment of a Loan,” (SFAS 114). The fair values of impaired loans
are 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
represent loans for which the fair value of expected repayments or collateral
exceed the recorded investment in such loans.  At June 30, 2009,
substantially all of the totally impaired loans were evaluated based upon the
fair value of the collateral. In accordance with SFAS 157, impaired loans where
an allowance is established based on the fair value of collateral require
classification in the fair value hierarchy.  When the fair value of
the collateral is based on an observable market price or a current appraised
value, the Company records the loan as nonrecurring Level 2.  When an
appraised value is not available or management determines the fair value of the
collateral is further impaired below the appraised value and there is no
observable market price, the Company records the loan as nonrecurring Level
3.




Assets
and Liabilities Recorded as Fair Value on a Nonrecurring Basis




The
Company may be required from time to time to measure certain assets at fair
value on a nonrecurring basis in accordance with GAAP. These include assets that
are measured at the lower of cost or market that were recognized at fair value
below cost at June 30, 2009.  Assets measured at fair value on a
nonrecurring basis are included in the table below:





Assets:
                  
                  Carrying
                    Value
                    (Fair Value)
                  
                  
                  Quoted Prices
                    (Level 1)
                  
                  
                  Significant Other Observable
                    Inputs (Level 2)
                  
                  
                  Significant
                    Unobservable
                    Inputs (Level 3)Impaired
      Loans
                  
                  $
                  4,248,063
                  
                  
                  
                  -
                  
                  
                  $
                  4,248,063
                  
                  
                  
                  -Other
      Real Estate
                    Owned
      -Held for sale
                  
                  $
                  4,590,110
                  
                  
                  
                  -
                  
                  
                  $
                  4,590,110
                  
                  
                  
                  -


-13-


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





Portions of this report contain
“forward-looking statements,” as that term is defined in the Private Securities
Litigation Reform Act of 1995.  Such forward-looking statements are
based on management’s expectations, estimates, projections and
assumptions.  These statements may be identified by the use of
forward-looking words or phrases such as “should”, “expects”, “anticipates”,
“plans”, “believes”, “estimates”, “might result”, “projects” and variations of
such words and similar expressions. These statements are not guarantees of
future performance and involve certain risks and uncertainties that are
difficult to predict.  Therefore, actual future results and trends may
differ materially from what is indicated in forward-looking statements due to a
variety of factors.  Such risks and uncertainties include liquidity
risks associated with our investor notes payable on demand by the holders, other
loans and short-term borrowings, delinquencies in our loan portfolio, capital
levels, changes in market interest rates, inability to generate new loans, and
competitive factors in our marketplace. These risks and uncertainties are
described in detail in the Company’s Annual Report on Form 10-KSB for the year
ended December 31, 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.





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 primarily of purchasing mortgage loans (approximately 80% of our
business) and of originating, acquiring and servicing mortgage loans
(approximately 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, during the last three years we
enjoyed only a six-month window of opportunity during which we were able to
publicly offer and sell our investor notes and, thus, raise much-needed cash, as
our most recent registration statement was declared effective on November 10,
2008 and expired on April 30, 2009.  During this time, our operations
have been funded solely through loan pay-offs, interest and other income
received on our loans, and unsecured short-term borrowings.





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.




Starting in the fourth quarter of 2004,
we expanded the distribution for our investor notes by engaging in strategic
alliances with several major financial services firms throughout the
country.  We currently have a signed selling agreement with a FINRA
registered broker-dealer with a network of over 400 registered representatives
in the Midwest and West.  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.


-14-


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.  The Company’s
overall business strategy is to grow and enhance our profitability by increasing
our portfolio of mortgage and business loans.  In addition, we may
seek to raise funds through private sales of our capital stock.  As
noted above, however, our ability to raise funds for operations during the past
three years has been very limited.





As
previously reported, the Company is in the process of selling a major portion of
its Other Real Estate Owned, which had a carrying value of about $5.68 million
at June 30, 2009, and has already listed for sale about $3.57 million of these
properties.  The Company is also aggressively pursuing the collection
of $4.25 million in impaired loans on its books at June 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.





Critical
Accounting Policies





Our significant accounting policies are
disclosed in Note A to the audited financial statements included in our Annual
Report on Form 10-K for the year ended December 31, 2008.  Management
believes the following significant accounting policies also are considered
critical accounting policies:





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





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





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





Assets.  Total
assets increased by $0.39 million, from $44.85 million at December 31, 2008 to
$45.24 million at June 30, 2009.  The size of our loan portfolio
decreased by $0.98 million ending at $35.88 million.  The increase in
total assets resulted primarily from our sale of 500,000 shares of common stock
during the first quarter of 2009.





Liabilities.  Total
liabilities increased by $0.81 million from $45.23 million at December 31,
2008 to $46.04 million at June 30, 2009.  The net increase was
primarily due to a $0.83 million increase in collateralized notes payable for
loans against Other Real Estate Owned.





Deficit.  Total
stockholders’ deficit increased by $0.42 million from $(0.38) million at
December 31, 2008 to $(0.80) million  at June 30, 2009.  The
increase was due to a net loss of $0.93 million offset by the sale of 500,000
shares of common stock at $1.00 per share.





Past Due Loans.  At
June 30, 2009, we held 27 loans that were more than 90 days past due but still
accruing interest, compared to 21 at December 31, 2008.  The total
principal and interest due on these loans was $11.58 million at June 30, 2009,
compared to $10.01 million at December 31, 2008.  Twenty-one of the
loans, totaling $6.88 million, are first mortgage loans on which we do not
expect to suffer any loss due to the underlying collateral
values.  The borrowers under six of the remaining loans, totaling
$0.58 million, are making scheduled payments.  One loan, totaling
$4.12 million, is expected to start paying current interest.  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.


-15-


Non-Accrual
Loans.  At June 30, 2009, there were 17 loans in non-accrual
status with an outstanding principal balance totaling $4.25 million, compared to
20 loans at December 31, 2008 with an outstanding principal balance of $4.04
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 June 30, 2009, we had a specific reserve of
$527,933 and a general reserve of $215,632 as part of our total reserve of
$743,565 for anticipated and unanticipated loan losses.





Comparison
of Operating Results for Six Months Ended June 30, 2009 and 2008





Net interest margin. The
average yield earned on loans receivable was 9.48% for the six months ended June
30, 2009 and 10.02% for the six months ended June 30, 2008.  The
average rate paid on investor notes decreased to 6.06% for the six months ended
June 30, 2009 from 6.78% for the six months ended June 30,
2008.  Overall, the net margin on interest increased to 3.42% for the
six months ended June 30, 2009, from 3.24% for the six months ended June 30,
2008.  This net margin is calculated using contractual rates and
excludes fee income and expense.  The calculation also excludes
interest expense associated with Collateralized Notes Payable and Loans Sold
with Recourse.





Net Loss.  Net loss
for the six months ended June 30, 2009 was $931,493, compared to a net loss of
$292,903 for the six months ended June 30, 2008.  The difference was
primarily due to a decrease in net interest income during the 2009 period when
compared to the 2008 period because of a decrease in interest earning assets as
a direct result of our limited ability to raise funds through the public sale of
our investor notes.  In addition, we had an increase in our provision
for loan losses.





Interest
Income.  Total interest income was $1.61 million for the six
months ended June 30, 2009, compared to $2.27 million  for the same
period in 2008.  The decrease in interest income was due primarily to
a decrease of $0.66 million in interest earned on loans between the two periods
because a significant amount of our higher-rate loans have paid
off.  The decrease in interest earned on loans also resulted from a
decline in our loans receivable portfolio due to normal payoffs and a lack of
loan originations and purchases.  Interest income includes loan and
fee income and interest earned on bank investments and marketable
securities.





Interest
Expense.  Interest expense was $1.49 million for the six months
ended June 30, 2009, and $1.84 million for the corresponding period in
2008.  The decrease in interest expense was a result of a decrease in
total investor notes payable due to increased redemptions during the period when
compared to the same period of last year.  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 $353,038 for the six
months ended June 30, 2009, compared to $154,098 for the six months ended June
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
Income.  We had non-interest income of $73,416 during the six
months ended June 30, 2009, compared to $52,886 for the corresponding period in
2008.  The increase was primarily due to increased rental income
during the six months ended June 30, 2009 and a gain on the sale of real estate
owned during the same period.





Non-Interest
Expense.  Non-interest expense increased to $764,143 for the
six months ended June 30, 2009 from $616,264 for the six months ended June 30,
2008.  The increase was due to larger legal and accounting fees that
were recognized during the six-month period ended June 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 June 30, 2009 and 2008





Net interest margin. The
average yield earned on loans receivable was 9.53% for the three months ended
June 30, 2009 and 9.69% for the three months ended June 30, 2008.  The
average rate paid on investor notes decreased to 6.08% for the three months
ended June 30, 2009 from 6.64% for the three months ended June 30, 2008, due
primarily to a decrease in the contractual rates we are required to pay on
investor notes. Overall, the net margin on interest increased to 3.45% for the
three months ended June 30, 2009, from 3.05% for the three months ended June 30,
2008.  This net margin is calculated using contractual rates and
excludes fee income and expense.  The calculation also excludes
interest expense associated with Collateralized Notes Payable and Loans Sold
with Recourse.


-16-




Net Loss.  Net loss
for the three months ended June 30, 2009 was $583,379 compared to a net loss of
$197,980 for the three months ended June 30, 2008.  The difference was
primarily due to a decrease in net interest income during the 2009 period when
compared to the 2008 period because of a decrease in interest earning assets, as
a direct result of our limited ability to raise funds through the public sale of
our investor notes, and a reduced net margin.




Interest
Income.  Total interest income was $795,211 for the three
months ended June 30, 2009, compared to $1,052,343 for the same period in
2008.  The decrease in interest income resulted from a decrease in
loans receivable portfolio due to normal payoffs and a lack of loan originations
and purchases.  The interest income includes point and fee income and
interest earned on bank investments and marketable securities.




Interest
Expense.  Interest expense was $760,572 for the three months
ended June 30, 2009 and $872,472 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 $319,310 for the
three months ended June 30, 2009 and $75,000 for June 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
Income.  We had non-interest income of $51,240 during the three
months ended June 30, 2009, compared to  $23,217 for the corresponding
period in 2008.  The difference was primarily due to a gain from the
sale of other real estate owned and  increased rental income during
the period ended June 30, 2009 when compared to the same period of
2008.




Non-Interest
Expense.  We experienced an increase in non-interest expense to
$349,948 for the three months ended June 30, 2009 from $326,068 for the three
months ended June 30, 2008.  Decreases in offering costs,
administration expense, real estate maintenance and insurance were offset by an
increase in professional fees during the period ended June 30, 2009 when
compared to the same period of 2008.




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 June 30, 2009, we had cash and cash
equivalents of $1,697 (.004% of total assets), a historically low level,
compared to $221,463 at December 31, 2008 (0.50% of total assets) and $209,224
(0.43% of total assets) at June 30, 2008.  During the first six months
of 2009, we received approximately $0.77 million in loan payments, which
included unscheduled prepayments and payments due at maturity, and we paid
approximately $3.03 million to redeem investor notes.





For the six months ended June 30, 2009,
net cash used by operating activities was $112,925, compared to $2,083,319 that
was provided by operating activities for the six months ended June 30,
2008.  The primary reasons for the decrease were a $931,493 net loss
for the period and an increase of $579,241 in interest receivable on loans for
the six months ended June 30, 2009.





For the six months ended June 30, 2009,
net cash provided by investing activities was $381,613, compared to $3,591,284
for the same period in 2008.  Cash provided by investing activities
for the six months ended June 30, 2009 included $772,538 in principal repayments
on loans receivable offset by $356,462 in loans made to borrowers, compared to
$9,291,650 in principal repayments on loans receivable and $5,199,922 in
offsetting loans made to borrowers for the six months ended June 30,
2008.





For the six months ended June 30, 2009,
net cash used in financing activities was $488,454, compared to $5,561,001 for
the same period in 2008.  During the 2009 period, net proceeds from
the sale of collateralized note payables were $1,043,945 and proceeds from the
sale of investor notes were $1,504,266, while investor note redemptions during
the 2009 period totaled $3,026,712.


-17-


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 above, 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 intend to  file the necessary
information with our securities regulators to recommence our public offering
efforts, this process can require significant time and cash resources so there
can be no guaranty as to when, if at all, 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.





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 June 30, 2009, we held approximately
$28.02 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.  However, in the current economic
market, we believe the price we could obtain for these loans would be below
their par values.  Accordingly, we are instead focused on selling
non-interest earning assets, such as our Other Real Estate Owned, to satisfy
pending investor redemption requests.  We held $1.35 million in second
mortgage loans at June 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.  There can be no
assurance that our efforts will be successful, as the national and local
economies and, specifically, the real estate market, have significantly weakened
during the past two years due in large part to the widely-reported problems in
the sub-prime mortgage loan market and the resulting global banking
crisis.





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 June 30,
2009, we were subject to redemption requests with respect to approximately $0.35
million of outstanding investor notes that are within the 30-day grace period
for payment.  Further, we were subject to redemption requests with
respect to approximately $3.87 million of outstanding investor notes that are
beyond the 30-day grace period for payment.  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.  Because there are some
notes for which we have not yet obtained waivers, 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.  (Jim to update above highlighted
information.)


-18-


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





Series
      3 Demand Notes
                    
                    BalanceOne
      Day
                    
                    $
                    5,224,400Thirty
      Day
                    
                    $
                    10,433,865Series
      3 Fixed Term Notes:Due
      within 1 year
                    
                    $
                    8,815,626Due
      in 1 to 3 years
                    
                    $
                    5,623,807Due
      in 3 to 5 years
                    
                    $
                    6,081,992Series
      4 Fixed Term Notes:Due
      within 1 year
                    
                    $
                    975,199Due
      in 1 to 3 years
                    
                    $
                    337,213Due
      in 3 to 5 years
                    
                    $
                    1,205,104Subtotal
                    
                    $
                    38,697,206Unamortized
      brokerage costs
                    
                    
                    (48,707
                    )Total
      investor notes, net
                    
                    $
                    38,648,499





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 seven years, from 10.6% at December 31,
1999 to a deficit of (1.76)% at June 30, 2009.  During the six-month
period ended June 30, 2009, we experienced an operating loss of $931,433
combined with stock issuances of $500,000 resulting in an ending stockholders
deficit of $801,856.





Sub-Prime Loans and
Lending.  Recently, the sub-prime mortgage lending environment
has experienced considerable strain from rising delinquencies and liquidity
pressures, as well as the banking, investment and other practices of the
industry in respect of sub-prime mortgage loans.  Several high profile
sub-prime mortgage lenders have failed, and these failures have had a very
materal, adverse impact on the financial markets and economy in
general.  In fact, these problems in the sub-prime market have been
largely responsible for a global economic recession and banking
crisis.  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 June 30, 2009 our sub-prime
loans amounted to only $2.47 million, or 7.71% 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.  However, this risk applies equally to all of our
loans.





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.


-19-


An evaluation of the effectiveness of
these disclosure controls as of June 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 first two quarters 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.





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.  The following discussion
updates a risk factor that was contained in our Annual Report:


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We
have failed to comply with the terms of our outstanding notes and the underlying
indenture.





Under the terms of the Indenture
relating to our investor notes, we are required to repay investments in full at
maturity and satisfy redemption requests in full within certain time periods,
depending on the type of note that has matured or is being
redeemed.  If we fail to make these payments as and when due and that
failure continues for 30 days after that date, we are required to promptly
notify the Indenture Trustee and we will be in default under the Indenture
unless each of the holders waives our timely compliance.  If we are in
default, both the Indenture Trustee and the holders of at least 25% in principal
amount of our outstanding investor notes have the right, for so long as that
default is continuing, to accelerate our payment obligations under all of our
outstanding notes.





As of June 30, 2009, we were subject to
redemption requests with respect to approximately $0.35 million of outstanding
investor notes that are within the 30-day grace period for
payment.  Further, we were subject to redemption requests with respect
to approximately $3.87 million of outstanding investor notes that are beyond the
30-day grace period for payment.  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.  Because there are some notes for which
we have not yet obtained waivers, 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.  There can be no guaranty that the Trustee and/or the
holders will not declare a default.  (Jim to update above highlighted
information.)





Because
the sum of principal and accrued interest due on our outstanding investor notes
exceeds our cash balances and other sources of immediate liquidity, we would
likely have to liquidate our assets if the Indenture Trustee or our holders were
to accelerate our outstanding notes.  If we were forced to liquidate,
our assets would be used first to satisfy the Series 3 investor and any other
senior debt, and then to satisfy the Series 4 investor notes, our short-term
borrowings, and the obligations owed to our other creditors.  Any
assets remaining after such distributions would be distributed pro rata to the
holders of our common stock.





It should
be noted that a majority of our assets are loans, many of which are secured by
real estate.  The national and local real estate markets have
experienced a significant downturn during the past two
years.  Accordingly, if we are forced to liquidate, there can be no
assurance that we would be able to sell our assets at the times or the prices
that we desire.  In addition, we had no available-for-sale investment
securities at June 30, 2009.  Because of the foregoing, holders of our
securities could lose all or a part of their investments if we were to become
insolvent or forced to liquidate and our assets at that time were not sufficient
to satisfy our obligations to those holders.  See Item 2 of Part I of
this report under the heading “Liquidity and Capital Resources” for further
information about this risk.





Other than as discussed above, we
believe that there has been no material change in any of the risk factors
discussed in our Annual Report on Form 10-K for the year ended December 31,
2008.





Item
3.  Defaults Upon Senior Securities





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





Item
6.  Exhibits





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





SIGNATURES





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





KH FUNDING COMPANY(Registrant)Dated:
      August 13, 2009
              /s/
      Robert L. HarrisRobert
      L. HarrisPresident,
      Chief Executive Officer, and Acting Chief
                Financial
      Officer


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EXHIBIT
INDEX





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


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