UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


WASHINGTON,
DC 20549










FORM
10-K





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





For the fiscal year
      ended December 31,
      2008


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 0-14237





KH FUNDING
COMPANY


(Exact
name of registrant as specified in its charter)





Maryland
            
            52-1886133(State
      or other jurisdiction of incorporation or organization)
            
            (I.R.S.
      Employer Identification Number)10801 Lockwood Drive,
      Suite 370, Silver Spring, Maryland
            
            20901(Address
      of principal executive offices)
            
            (Zip
      Code)





Registrant’s
telephone number, including area code:  (301) 592-8100





Securities
registered pursuant to Section 12(b) of the Act: None




Securities
registered pursuant to Section 12(g) of the Act: None





Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.


Yes £
No R





Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or 15(d) of the Act.


Yes £
No R





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 such shorter period that the registrant was required to
file such reports), and (2) has been subject to such filing requirements for the
past 90 days. Yes R
No £





Indicate
by check mark if disclosures of delinquent filers pursuant to Item 405 of
Regulation S-K (Section 229.405 of this chapter) is not contained herein, and
will not be contained, to the best of the registrant’s knowledge, in definitive
proxy or information statements incorporated by reference in Part III of this
Form 10-K or any amendment to this Form 10-K.R





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
definition of “accelerated filer”, “large 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 R





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





There is
no established market for the registrant’s common equity.  The
aggregate market value of the registrant’s voting and non-voting common equity
held by non-affiliates, based on the price known to the registrant at which the
common equity was last sold as of the last business day of the registrant’s most
recently completed second fiscal quarter, was:  $4,470,362.





The
number of shares of the registrant’s common stock outstanding as of March 31,
2009:  3,074,981









PART I




This Annual Report of KH Funding
Company on Form 10-K contains forward-looking statements within the meaning of
The Private Securities Litigation Reform Act of 1995.  Readers of this
report should be aware of the speculative nature of “forward-looking
statements.”  Statements that are not historical in nature, including
the words “anticipate”, “estimate”, “should”, “expect”, “believe”, “intend”, and
similar expressions, are based on current expectations, estimates and
projections about (among other things) the industry and the markets in which KH
Funding Company operates; they are not guarantees of future
performance.  Whether actual results will conform to expectations and
predictions is subject to known and unknown risks and uncertainties, including
risks and uncertainties discussed in this Form 10-K, general economic, market or
business conditions; changes in interest rates, the cost of funds, and demand
for loan products and services; changes in our competitive position or
competitive actions by other companies; changes in the quality or composition of
loan and investment portfolios; the ability to mange growth; changes in laws or
regulations or policies of federal and state regulators and agencies; and other
circumstances beyond our control.  Consequently, all of the
forward-looking statements made in this document are qualified by these
cautionary statements, and there can be no assurance that the actual results
anticipated will be realized, or if substantially realized, will have the
expected consequences on our business or operations.  For a more
complete discussion of these and other risk factors, see Item 1A of Part I of
this annual report.  Except as required by applicable laws, we do not
intend to publish updates or revisions of forward-looking statements we make to
reflect new information, future events or otherwise.





As used in this annual report, the
terms “Company”, “KH Funding” and “we”, “our”, and “us” refer to KH Funding
Company.





ITEM 1. BUSINESS




General




KH
Funding conducts mortgage banking operations from its headquarters in Silver
Spring, Maryland. Our primary business activities consist of originating,
acquiring and servicing mortgage loans, and issuing interest bearing debt
securities to investors (“investor notes”).  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.





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.




Operations





We
operate from a suite of offices located in Silver Spring, Maryland. We act as a
mortgage banker or purchaser of mortgage and business loans and perform the
record keeping, loan administration and servicing functions with regard to our
assets and liabilities. We also administer our program of issuing and selling
fixed and variable rate debt securities of varying maturities. For example, our
mortgage loan servicing includes collecting payments, paying property taxes and
insurance, and if necessary, instituting foreclosure procedures. In addition, in
February 2003 we were approved by the Internal Revenue Service as a retirement
account trustee. We accept and administer purchases of our investor notes for
IRA and SEP accounts. Currently, these services are provided by KH Funding
personnel that have other responsibilities; however, we intend to expand these
trust services in the future.





Our
assets of $44.85 million at December 31, 2008 consisted primarily of cash,
mortgages and real property.  In the normal course of business, we
collect the income generated by the assets; receive funds from investors; handle
the redemption of investor notes; and maintain and track the receipts,
disbursements and balances on escrow accounts established by the
borrowers.





The
following table sets forth certain information relating to KH Funding for the
five years ended December 31, 2008. The average yield and cost of funds are
derived by dividing interest income or interest expense by the average balance
(exclusive of nonaccrual loans and of unamortized fees and costs) of loans
receivable or investor notes, respectively, for the years shown. The interest
categories are at contract rates and exclude the amortization of related fee
income and expense.




2





Year
            
            Average
      Yield
              Loan
      Portfolio
            
            
            Cost
      of Funds
              Investor
      Notes
            
            
            Net
      Interest
              Rate
      Spread2004
            
            
            10.89
            %
            
            
            5.69
            %
            
            
            5.20
            %2005
            
            
            10.66
            %
            
            
            6.03
            %
            
            
            4.63
            %2006
            
            
            11.05
            %
            
            
            6.53
            %
            
            
            4.52
            %2007
            
            
            10.65
            %
            
            
            7.09
            %
            
            
            3.56
            %2008
            
            
            9.89
            %
            
            
            6.67
            %
            
            
            3.22
            %




Technology





We
maintain an off-site secondary location which has full back-up operability with
up-to-date information. The software we use to track our loan portfolio is used
commercially by over 300 other subscribers. Our investment account software was
made to our specifications to allow us to service the holders of our investor
notes in an efficient and timely manner.




Customer
Service





We provide monthly statements and
timely, personal service to our investors, which have always cultivated a good
“word-of-mouth” referral system. We have developed and made available to our
investors on-line access to their accounts at our Internet website,www.khfunding.com.  The website allows
investors to view their account information at anytime, such as account
balances, maturity dates and recent transactions, and to complete transfers from
one account to another account, order wire transfers, and request
withdrawals.




Business
Strategy





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





Starting
in the fourth quarter of 2004, we expanded the distribution for our investor
notes by engaging in strategic alliances with several major financial services
firms throughout the country.  We currently have signed selling
agreements with one FINRA registered broker-dealers with a network of over 400
registered representatives across the country.  These alliances have
given us the ability to sell our investor notes through a network of financial
intermediaries in defined geographic locations.  To date, during the
period we were able to offer our investor notes, our distribution plan has been
very successful, establishing close to 700 new investment accounts providing us
with over $25,000,000 in funds.  In 2006, sales by these
broker-dealers established approximately 522 new investment accounts and
provided over $11 million in funds.  We plan to further increase our
distribution network, and are currently in negotiations with other FINRA member
broker-dealers interested in distributing our investor notes in parts of the
United States where we are not currently represented.





Our
business strategy has been hampered in recent years because of delays in
obtaining an effective registration for our investor notes in Maryland and,
thus, raise funds through the sale of investor notes in or from Maryland, our
largest market.  This delay resulted from (i) an investigation
instituted by the Division of Securities of the Office of the Maryland Attorney
General (the “Maryland Securities Division”) relating to our unregistered sale
in 2006 of investor notes from Maryland and (ii) reviews by the Securities and
Exchange Commission (the “SEC”) and the Maryland Securities Division of our 2006
registration statement and subsequent amendments and a resulting investigation
by the Maryland Securities Division, which we were required to address before
our registration statement could be declared effective.  In connection
with the first investigation, the Maryland Securities Division required us to
redeem an aggregate of $464,511.07 in investor notes that were sold to
unaccredited investors, offer accredited investors the right to rescind their
purchases of investor notes, and enter into a Consent Order in December 2007
finalizing this matter.  In November 2008, we entered into another
Consent Order to finalize the registration statement review and related
investigation.





We intend
to continue managing our assets and maintaining strict collection procedures for
any problem assets in order to increase our profitability. We expect to realize
more operating efficiencies and cost controls as we invest the proceeds from
future offerings, as we do not expect significant additional personnel or
facilities will be needed.




3





Market
Area and Credit Risk Concentration





Our
lending activities are concentrated primarily in Washington, D.C., the Maryland
counties of Anne Arundel County, Baltimore County, Frederick County, Howard
County, Montgomery County, and Prince Georges County, and Baltimore City,
Maryland and, to a lesser degree, Northern Virginia.  We also purchase
residential mortgage loans from banks and other lenders in other
states.  Loans in our local market areas made up approximately 96% of
our total loan portfolio at December 31, 2008, and our average loan size across
our entire portfolio was approximately $280,000.  Overall, since
December 31, 2006, we have observed a 10% to 20% decrease in the median sales
price for real estate in these markets.  Moreover, as has been widely
reported in the news media, the national economy has deteriorated significantly
over the last year, and this deterioration has had a significant adverse impact
on the financial services industry as a whole, businesses and employers, and
commercial and consumer borrowers.  Although the Maryland economy
seems to be faring better than in many other parts of the country, the local
economy has nevertheless suffered as a result of recent events.  Our
larger loans, above $250,000, are made with a strong emphasis on
collateral-based underwriting as opposed to relying primarily on credit
scoring.





Competition





We face
significant competition both in making loans and in attracting investor funds.
Our competition for loans comes principally from commercial banks, mortgage
companies, insurance companies and other financial service companies; often
these are local (and sometimes smaller) independent loan companies or
individuals. Our competition for investor funds has historically come from
competitors offering uninsured products, such as the mutual fund industry,
securities and brokerage firms and insurance companies, as well as insured money
market accounts and certificates of deposit at commercial banks.





Our
experience has been that, in originating loans and acquiring loans, there has
been increased competition from large institutions. We do not believe that this
trend is material to our financial condition or operations at this
point.  However, if this trend continues, it is possible that we may
have difficulty originating or obtaining loans that meet our standards or that
we will have difficulty competing with these larger originators, which often
enjoy a lower cost of funds.





Our one,
three and five year fixed term investor notes are priced at rates that are
normally more than 200 basis points (2%) above insured investments for a similar
term at commercial banks. Our one day and 30 day investor notes are
competitively priced with other uninsured investments that have similar features
such as checking account and withdrawal features. We provide holders of our one
day demand notes with KH Funding-investor joint checking accounts through Bank
of America and other local banks to access their funds (this feature is not
offered to South Carolina residents). The checking account privileges are
exclusively for funds invested in investor notes and allow the holders of one
day demand notes to execute redemption or investment requests conveniently,
quickly and with less expense than by wire transfer or the mail. The holder may
write a check against the account, which reduces the note balance. The holder
may add to their investment by making deposits at the bank through which the
checking accounts are provided.





Lending
Activities





Our loan portfolio consists primarily
of first and second mortgage loans that we have originated or acquired from
other lenders. We also hold several business line-of-credit and fixed-term loans
that we have directly originated. A small portion of our portfolio contains
loans for consumer purposes such as auto and personal loans, and a few loans
secured by the borrower’s non-real estate assets, such as stock.





Some of the mortgage loans we make and
acquire are considered “sub-prime loans”.  Sub-prime mortgage loans
generally have higher delinquency and default rates than mortgage loans made to
prime borrowers.  At December 31, 2008, our sub-prime loans
represented 9.73% of our total loans.  We attempt to manage these
risks with risk-based mortgage loan pricing, appropriate underwriting policies,
appropriate loan collection methods, and reliance on the “hard-collateral” value
of the underlying collateral for each loan.  We believe that our
exposure to problems in the sub-prime market is limited as a result of several
factors.  First, we believe that we are underwriting our sub-prime
mortgage loans to a higher standard than the failing and delinquent loans from
the more aggressive lenders in the mortgage industry. Second, we do not offer
the loan products that are receiving the harshest criticism from regulators,
commentators and Congress.  Notably, as a general matter, the
sub-prime loans that we originate or purchase have loan to value (“LTV”) ratios
at the time the loan is made 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. Third, our size does not require us to generate or purchase high volumes
of sub-prime mortgage loans so we can look much more closely at the individual
borrowers, as in the case of loans that we originate. In the case of purchased
loans, we rely on strict purchase criteria relating to LTV ratios and
documentation.




4





We rely
on community contacts as well as referrals from existing customers, attorneys
and real estate professionals to generate business within our lending area. In
addition, we have developed a list of brokers, banks and lenders nationwide that
sell us loans.





We have
developed underwriting policies to control the inherent risks in the origination
and acquisition of loans. The policies address approval limits, loan-to-value
ratios, appraisal requirements, debt service coverage ratios, loan concentration
limits and other matters relevant to loan underwriting.




First
Mortgage Lending





Direct Origination. We
originate first mortgage loans primarily for investment (rented) residential
real estate and small commercial properties. The loans we originate normally
have a LTV ratio of 80% or less and are made to investors, or “non-occupant
owners”. We use credit scores to determine the creditworthiness of the
borrowers. Credit scores are determined by complex computer programs which take
into consideration many factors. There are three companies that are the primary
providers of credit reports and credit scores for individuals. We generally
obtain credit reports and/or credit scores from all three companies, and are a
member of one, Equifax. Credit scores range from the 400’s to the 800’s. The
lower the credit score, the lower the creditworthiness of the individual. Credit
scores below 600 will generally indicate a sub-prime borrower. A credit score of
600 to 680 is a borrower that pays their bills but not always on time, and a
credit score above 680 is a creditworthy borrower. Lenders adopt different
guidelines for acceptability regarding credit scores. For us, a credit score of
580 to the 800’s (the highest score possible) is within the range of
acceptability in order to make or acquire a loan, however, we prefer the credit
score to be in the mid-600’s and above. The borrowers with a score below the
mid-600’s must provide us with a reason, or reasons, which mitigate the below
mid-600’s score.




Acquired
Loans.  The first mortgage sub-prime loans we acquire generally
have LTV ratios of 70% or less.  The majority of these loans are for
the purchase of owner-occupied properties and the interest rates are usually
between 9.5% to 11.5%.  Our loan portfolio has none of the aggressive
Adjustable-Rate-Mortgage loan products that are currently causing much of the
concern regarding sub-prime borrowers in the mortgage lending
industry.  The first mortgage loans we acquire that are not sub-prime
loans are primarily secured by non-owner occupied properties and made to
investors at LTV ratios of 80% or less, where the purpose of the loans is
typically to allow the investor to rehabilitate and lease or sell the
property.





At
December 31, 2008, 53.54% of our loans were first mortgage loans, made up of
$10.11 million in direct origination first mortgage loans and $10.00 million in
purchased first mortgage loans.





Second
Mortgage Lending





Direct Origination. The
majority of the second mortgage loans we have originated are debt consolidation
loans and are secured by owner-occupied properties.  We typically do
not hold the first mortgage on these properties.  The LTV ratios on
these loans can be as high as 100%. The borrowers’ credit scores generally start
at 580 and average in the low 600s. We have originated very few of these loans
in the past few years and do not anticipate that we will make many of these
loans in the future.




Acquired Loans. We only
acquire second mortgage loans if they have a total LTV ratio of less than 80%.
We formerly purchased loans with LTV ratios of up to 125%, but we discontinued
that practice in 2000.  We also greatly curtailed purchasing
stand-alone second mortgage loans in 2000, as we would prefer to also own the
first mortgage when an acquired loan has a combined LTV ratio greater than 80%.
However, if borrowers have a credit score in the low to mid 600s or higher, we
will purchase a stand-alone second mortgage loan, although we do not do so very
often.





The
second mortgage loan portion of our loan portfolio represented only 3.94% of our
total loan portfolio at December 31, 2008.





Business
Lending





We directly originate loans to small
businesses. We do not acquire small business loans. Most of the loans we make of
this type are for businesses generating less than $1,000,000 in gross revenue.
If the business owns real estate, we will obtain a lien on the property(ies)
owned by the business as part of our loan. We will also normally place a lien on
the primary residence of the owner(s) of the business. We are still a hard
collateral lender when we make business loans, i.e., we are still more
collateral-sensitive when making business loans than we are "cash flow"
sensitive. In other words, if we are considering a loan for a development stage
or start-up business and we find the business plan or the results of operations
for the business borrower to be acceptable, and the credit score of the borrower
to be at the high end of our range of acceptability, then we will make the loan
provided we are adequately secured with real estate collateral. Generally, the
cash flow will not be present at the time the loan is closed, but will be
expected to develop with the use of the loan proceeds. However, we do require
that the borrowers have good credit and a reasonable ability to repay the loan.
In the instances in which a business has accounts receivable as a primary source
of repayment we will obtain a lien on the accounts receivable.




5





At
December 31, 2008, loans in this category made up 4.20% of our total loans,
which are also considered part of the first mortgage loan category.




Other
Assets Lending




Some of
the loans in our portfolio are not secured by real estate or business assets.
Automobiles and investor notes secure the majority of these loans. These types
of loans are generally made to borrowers with whom we have a long-standing
relationship.





At
December 31, 2008, loans in this category made up 3.45% of our total
loans.





Unsecured
Lending




Unsecured
loans represented 0.88% of our loan portfolio at December 31,
2008.  The majority of these loans are for small amounts, under
$25,000, made to borrowers with whom we have a long-standing relationship, or
who have been referred to us by our trusted customers. A few of these loans are
to borrowers, with whom we originally had a collateralized loan, but the
collateral has been foreclosed upon or has been reduced in value and the
balances represent the deficiency or a recognition that no collateral with real
value exists for the loan.





The
following table sets forth the composition of our loan portfolio by collateral
type in dollar amounts for the periods indicated:




Year
      Ended December 31,Loans
      By Collateral Type
            
            2008
            
            
            2007Residential
      Real Estate – First Mortgage
            
            $
            9,462,159
            
            
            $
            11,441,120Business
      Assets and Commercial Real Estate
            
            
            1,577,300
            
            
            
            3,049,002Investment
      Property
            
            
            23,049,958
            
            
            
            30,711,891Residential
      Real Estate - Second Mortgage
            
            
            1,478,526
            
            
            
            750,253Other
      Assets (Auto, Stock)
            
            
            1,296,720
            
            
            
            1,719,596Other
      Loans (Over Equity, Medical and Unsecured)
            
            
            329,462
            
            
            
            417,008Total
      loans receivable
            
            
            37,194,125
            
            
            
            48,088,870Unearned
      fees and other
            
            
            325,235
            
            
            
            291,798Less
      allowance for loan losses
            
            
            (659,242
            )
            
            
            (495,480
            )Total
      loans receivable, net
            
            $
            36,860,118
            
            
            $
            47,885,188




Loan
Approval Procedures and Authority





Our Chief Executive Officer may approve
any loan up to and including $500,000. Our Chief Executive Officer and another
member of our Board of Directors together must approve all loans over
$500,000.




Security of Loan
Collateral Procedures





We have no internal appraisers and, as
such, we rely on independent appraisers to determine the value of collateral
underlying a loan. For commercial property mortgage loans, in addition to an
independent appraisal, we generally require an environmental site assessment to
be performed. We also require title and hazard insurance on the property for all
first and second mortgage loans. We require a recorded deed of trust or
mortgage.  In addition, we may require borrowers to make payments to a
mortgage escrow account for the payment of property taxes and insurance. We
monitor these loans to ensure that all applicable taxes and insurance are timely
paid.




6





Investor
Notes





We raise
a significant amount of funds for operations by selling our investor notes,
which consist of “Series 3” senior secured debt and “Series 4” subordinated
unsecured debt.  The Series 3 notes are issued as one-day and 30-day
demand notes, with variable interest rates, and as one-year, three-year and
five-year fixed-rate notes.  Series 3 notes are secured by
substantially all of our current and future assets, excluding real estate owned
and rank senior to all unsecured and subordinated indebtedness of KH
Funding.  The Series 4 are issued as one-year, three-year and
five-year fixed-rate notes.  The Series 4 notes are unsecured and rank
junior to the Series 3 Notes and any other senior indebtedness we may incur, and
on parity with all other unsecured and subordinated indebtedness of KH
Funding.  Senior debt includes any indebtedness incurred in connection
with our borrowings from a bank, trust company, insurance company, or from any
other institutional lender.  Our current offering of investor notes
was declared effective by the Maryland Securities Division and the SEC on
November 10, 2008, and we have sold only a small amount of investor notes since
that date.  Our current registration statement cannot be used to offer
or sell securities after April 30, 2009 unless we amend it to include current
audited financial statements.





Governmental
Regulations





We may
from time to time be subject to federal and state laws and regulations relating
to banking or lending operations. These regulations may:





·
              require
      us to obtain and maintain additional licenses and
      qualifications;


·
              subject
      us to supervision of and examination by regulatory agencies;


·
              limit
      the interest rates, fees and other charges that we are allowed to
      collect;


·
              limit
      or prescribe other terms of our loan arrangements with borrowers;
      and/or


·
              subject
      us to potential claims, defenses and other
  obligations.





USA
PATRIOT Act





Congress adopted the USA PATRIOT Act
(the “Patriot Act”) on October 26, 2001 in response to the terrorist attacks
that occurred on September 11, 2001. Under the Patriot Act, certain financial
institutions are required to maintain and prepare additional records and reports
that are designed to assist the government’s efforts to combat terrorism. The
Patriot Act includes sweeping anti-money laundering and financial transparency
laws and required additional regulations, including, among other things,
standards for verifying client identification when opening an account and rules
to promote cooperation among financial institutions, regulators and law
enforcement entities in identifying parties that may be involved in terrorism or
money laundering.  The Patriot Act currently has limited application
to our business, in that it requires us to report certain client account
information to the federal Financial Crimes Enforcement Network (“FinCEN”) if
and to the extent requested by FinCEN.  In the future, amendments to
this law, and/or regulations promulgated thereunder, may impose additional
burdens on us.





Governmental
Monetary and Credit Policies and Economic Controls





The earnings and growth of the lending
industry and ultimately of KH Funding are affected by the monetary and credit
policies of governmental authorities, including the Board of Governors of the
Federal Reserve System (the “FRB”). An important function of the FRB is to
regulate the national supply of credit in order to control recessionary and
inflationary pressures. Among the instruments of monetary policy used by the FRB
to implement these objectives are open market operations in U.S. Government
securities, changes in the federal funds rate, changes in the discount rate of
member bank borrowings, and changes in reserve requirements against member bank
deposits. These means are used in varying combinations to influence overall
growth of bank loans, investments and deposits and may also affect interest
rates charged on loans or paid for deposits. The monetary policies of the FRB
authorities have had a significant effect on the operating results of lending
institutions in the past and are expected to continue to have such an effect in
the future. In view of changing conditions in the national economy and in the
money markets, as well as the effect of actions by monetary and fiscal
authorities, including the FRB, no prediction can be made as to possible future
changes in interest rates or loan demand or their effect on our business and
earnings.





Federal
Securities Laws





We are subject to information reporting
and other requirements of the Securities and Exchange Act of 1934 (the “Exchange
Act”).  The federal Sarbanes-Oxley Act of 2002 and the regulations
adopted in furtherance thereof made several changes to the Exchange Act to which
we are subject.  These changes impose additional requirements and
restrictions on us, including, among other things, restrictions on loans to and
other transactions with insiders, additional disclosure requirements in the
reports and other documents that we file with the SEC, and other corporate
governance requirements.




7





Environmental
Law





Certain environmental regulations may
affect our operations. For example, our ability to foreclose on the real estate
collateralizing our loans may be limited by environmental laws which pertain
primarily to commercial properties that require a current or previous owner or
operator of real property to investigate and clean up hazardous or toxic
substances or chemical releases on the property. In addition, the owner or
operator may be held liable to a governmental entity or to third parties for
property damage, personal injury, investigation and cleanup costs relating to
the contaminated property. While we would not knowingly make a loan
collateralized by real property that was contaminated, it is possible that the
environmental contamination would not be discovered until after we had made the
loan.





Future
Legislation





Periodically, the federal and state
legislatures consider bills with respect to the regulation of financial
institutions. Some of these proposals could significantly change the regulation
of the financial services industry. We cannot predict whether such proposals
will be adopted or their effect on us if they are adopted.





Although
we believe that we are currently in compliance with statutes and regulations
applicable to our business, there can be no assurance that we will be able to
maintain compliance with existing or future governmental regulations. The
failure to comply with any current or subsequently enacted statutes and
regulations could result in the suspension of our business activities and/or the
suspension or termination of the licenses on which we rely to conduct our
business, and such suspension or termination could have a materially adverse
effect on us.  Furthermore, the adoption of additional statutes and
regulations, changes in the interpretation and enforcement of current statutes
and regulations, or the expansion of our business into jurisdictions that have
adopted more stringent regulatory requirements than those in which we currently
conduct business could limit our activities in the future or significantly
increase the cost of regulatory compliance.





Insurance





We
maintain the following types of insurance for the benefit of KH
Funding:





·
              Bankers
      Bond: fidelity and theft coverage of $500,000;


·
              Mortgage
      Impairment: covers losses to properties when the borrower’s policy has
      expired;


·
              Property
      Damage-Vacant Properties: covers losses to properties immediately after we
      take title, if they are vacant;


·
              Liability
      Coverage-Vacant Properties: covers liability losses to individuals at
      vacant properties after we take title;


·
              Key
      Man Life: $2.7 million payable to KH Funding in the event of the death of
      Robert L. Harris;


·
              Key
      Man Disability: $12,000 per month payable for one year to KH Funding in
      the event of the disability of Robert L. Harris;


·
              Umbrella
      Liability: $2 million in excess liability coverage above any primary
      liability coverage that we maintain;


·
              Landlord
      Policies for Individual Rental Properties: basic insurance for rented
      properties;


·
              Health
      Insurance: maintained for the benefit of the employees;


·
              Business
      Owners Policy: comprehensive business and liability coverage;
      and


·
              Director’s
      and Officer’s Liability:  insurance protecting our directors and
      officers against liabilities arising in the course of their service to
      us.





Personnel





At
December 31, 2008, we had seven full-time employees (working more than 30 hours
per week) and two part-time employees (working fewer than 30 hours per
week.)




ITEM
1A. RISK FACTORS




Our
business, results of operations and financial condition are subject to a number
of risks, including the risks set forth below. You should carefully consider
these risks before making an investment decision with respect to our
securities.  Additional risks and uncertainties, including those that
are not yet identified or that we currently think are insignificant, may also
adversely affect our business, results of operations and financial condition
and, thus, your investment in KH Funding.




8





Risks
Specific to Our Business





We
may not continue as a going concern.





The
opinion issued by our independent registered public accounting firm with respect
to our audited financial statements for the year ended December 31, 2008
presented in Item 8 of Part II of this annual report contains a qualification to
the effect that the financial statements were audited based on the assumption
that we will continue as a going concern.  This opinion is also
presented in Item 8 of Part II of this annual report and should be considered
when reviewing our financial statements.





Between
May 2006 and November 2008, we were unable to sell any of our investor notes in
our markets, including Maryland, because of delays in obtaining an effective
registration for an offering.  Because the sale of our investor notes
is largely dependent on our ability to offer them from Maryland and/or to
Maryland residents, this delay significantly hampered our ability to raise funds
for operations and has created a significant risk that we may have difficulty
meeting our future liquidity needs.  Moreover, our current
registration statement covering the sale of our investor notes expires on April
30, 2009, so it must be amended and declared effective by the SEC and applicable
state securities regulators before we can sell our notes after that
date.  We have not yet filed an amendment to this registration
statement and, when we do, it is possible that the SEC and/or state securities
regulators may issue comments that will need to be addressed before the
registration statement may be declared effective.  Accordingly, there
can be no assurance that we will not experience additional delays with respect
to our selling efforts after April 30, 2009.





We
require cash to make and acquire loans, redeem outstanding investor notes, and
pay other operational expenses.  As discussed in the following risk
factor, we reported net losses for four of the last five fiscal years, including
2008.  Net investor note redemptions ($14.0 million) exceeded cash
received from principal loan repayments—unscheduled prepayments and payments at
maturity ($9.9 million)— by approximately $4.1 million.  In the
future, we may continue to report
losses and may not be able to timely satisfy our
obligations.Additionally, we had a stockholders’ deficit at
December 31, 2008 of 0.85% of total assets.  This negative capital
gives us no equity margin to protect us against potential future
losses.  Because of our recurring losses and stockholders’ deficit and
because future income from loans, cash needed for operations (including investor
note redemptions) and the success of our securities offerings and sales are
uncertain, there is substantial doubt about our ability to continue as a going
concern.  Ourfinancial statementspresented elsewhere in
this annual reportdo not
include any adjustments that mightresult from the outcome of these
uncertainties.





We
have experienced net losses in recent fiscal years and may not achieve
consistent profitability.





We reported net losses for the fiscal
years ended December 31, 2008, 2007, 2005 and 2004.  These losses were
attributable in large part to our inability to raise funds for operations by
selling our investor notes, although the declining market for real estate and
real estate secured loans and the significant deterioration of the economy have
also impacted operations.  We may not be able to generate profits on a
quarterly or an annual basis in the future.  If we continue to
experience net losses in future periods, we may not be able to timely satisfy
our obligations, including redemption requests by holders of our investor notes,
and these holders may lose all or part of their investments.





We
operate with limited capital levels and a stockholders’ deficit.





The timing and amounts of investor note
redemptions are unpredictable, and our financial condition could be materially
and adversely affected if we were to receive investor note redemption requests
in an amount that exceeds our existing cash resources, cash inflows from loans,
including unscheduled and unpredictable prepayments, proceeds from sales of
investor notes, and the cash we can obtain through the liquidation of our
saleable assets to satisfy those redemption requests.  We have always
attempted to hold 5% to 20% of our assets in cash and cash equivalents to fund
redemptions of one day demand notes, which has historically been sufficient for
us to meet our obligations, but at December 31, 2008 our cash and cash
equivalents approximated only 0.50% of our total assets.  Accordingly,
there can be no guarantee that we will raise funds through our securities
offerings or, if we do, that the funds raised will be sufficient to meet future
liquidity needs.





Capital
represents the amount that a corporation’s stockholders have invested in the
corporation at any point in time.  Generally, a stockholder’s right to
a return on his or her capital investment is subordinate to the other
obligations of the corporation.  Accordingly, in the event of a
dissolution or liquidation of the corporation, capital is paid only after all
persons who have a senior right to payment, such as preferred security holders
and holders of debt, have been paid.  A greater amount of capital
provides a greater amount of protection to debt holders in the event of a
liquidation or dissolution.





Historically,
a significant portion of our working capital has come from the proceeds of sales
of our investor notes, such as the Notes.  As discussed above,
however, we were prohibited from selling any of our investor notes between May
2006 and November 2008.  This delay severely limited our ability to
strengthen our capital position during the past three years and, in fact, has
had a material adverse effect on our capital resources.  In addition,
as of December 31, 2008, our debt-to-equity ratio is approximately (0.46%), and
stockholders’ equity at December 31, 2008 was 0.85% of our total
assets.  These levels are not considered adequate to fully protect our
investors against losses in the event we become insolvent or have to liquidate
and, accordingly, 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.




9





Further information about the rights of
our security holders and creditors upon liquidation, our current capital
resources and stockholders’ deficit, and our liquidity can be found in the risk
factor below entitled “We have failed to comply with the terms of our
outstanding notes and the underlying indenture” and in Item 7 of Part II of this
annual report under the heading “Liquidity and Capital Resources”.





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 satisfy redemption requests
by holders in full within certain time periods, depending on the type of note
that is being redeemed.  If we fail to satisfy a redemption request by
the date set for redemption 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 requesting 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.





Until October 10, 2008, we were subject
to redemption requests from 48 holders of our outstanding investor notes
(totaling approximately $1.79 million) that remained unsatisfied more than 30
days after the date set for redemption.  We contacted each of these
holders and/or their agents to discuss the situation.  All but three
of these requests (totaling $975,553) were satisfied on October 10, 2008, and
these three investors agreed to extend the dates set for redemption of their
notes.  We did not notify the Trustee regarding these late payments
until September 22, 2008, which was more than 30 days after the dates set for
redemption.





We had redemption requests from two
holders (totaling $101,521) for which the 30-day grace period expired on October
24, 2008 and October 25, 2008, respectively, but which were not satisfied until
October 28, 2008.  Accordingly, we were in default under the Indenture
for four calendar days.  On October 28, 2008, we notified the Trustee
of this situation and that these requests had been satisfied in
full.





As of
December 31, 2008, we were subject to redemption requests with respect to (i)
approximately $4.61 million of outstanding investor notes that are past the date
set for redemption but within the 30-day grace period for repayment and (ii)
approximately $1.75 million of outstanding investor notes that are past the
30-day grace period for repayment.  This fact, along with updates, are
regularly reported to the Indenture Trustee.  For so long as a default
is continuing, the Indenture Trustee or the holders of 25% of our outstanding
investor notes could accelerate all of our outstanding notes, in which case we
would be required to immediately pay the outstanding principal and accrued
interest due on such notes.





We have not received notice from either
the Trustee or the holders of 25% in principal amount of our outstanding
investor notes that they intended to assert a default or accelerate all
outstanding investor notes because of the situations described above and we have
no indication that such a default or an acceleration will be asserted, but there
can be no guarantee that the Trustee or the holders will not do so.





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 we were to default under the Indenture
and 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 in recent months.  Accordingly, if
we are forced to liquidate, there can be no guarantee 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 December 31,
2008 or December 31, 2007, compared to available-for-sale securities of $581,149
at December 31, 2006.  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 7 of Part II of
this annual report under the heading “Liquidity and Capital Resources” for
further information about this risk.




10





We
are subject to pending litigation the outcome of which could have a material
adverse impact on us.





On October 31, 2008, Samar Ghadry filed
a complaint against us and several other defendants in Montgomery County,
Maryland Circuit Court.  Ms. Ghadry’s complaint relates to the alleged
misappropriation of approximately $864,000 by a former Senior Vice President of
KH Funding, Martin Angeli.  Ms. Ghadry claims that Mr. Angeli sold
certain of Ms. Ghadry’s securities and unlawfully kept some of the
proceeds.  We are involved because Mr. Angeli allegedly caused these
funds to be wired to his mother’s investor account at KH Funding and then to an
account at another institution also owned by his mother.  In her suit
against us, Ms. Ghadry seeks the return of $864,000 plus punitive damages in the
amount of $5.0 million.  This litigation could subject us to
substantial legal expenses, and we cannot predict the outcome of this litigation
or its potential impact on us.  We have insurance policies that we
believe will cover up to $3.0 million of any judgment, but there can be no
guaranty that our insurance policies will cover any of these
claims.  Moreover, even if our insurance policies do cover the claims,
the aggregate amount that Ms. Ghadry is seeking exceeds our coverage by over
$2,864,000.  Accordingly, if Ms. Ghadry were to prevail, we might not
have sufficient funds to make payments to holders of our investor notes,
including the Notes, as and when they are due and you may lose some or all of
your investment.  Further information about this litigation is found
in Item 3 of Part I of this annual report.





We
have identified material weaknesses in our internal controls.





Based on its evaluation of the
effectiveness of our internal control over financial reporting as of December
31, 2008, our management has concluded that we had material weaknesses in
internal control over financial reporting and that, accordingly, our internal
control over financial reporting was not effective as of December 31,
2008.  A “material weakness” is defined as a deficiency, or a
combination of deficiencies, in internal control over financial reporting such
that there is a reasonable possibility that a material misstatement of the
annual or interim financial statements will not be prevented or detected on a
timely basis.  The material weaknesses related to the
following:





·
              Lack
      of tangible audit trail, such as documentation, dates and signatures of
      the performance of control activities such as review of journal entries,
      reconciliation of accounts and valuation of collateral and
      properties.


·
              We
      had one person, Mr. Harris, performing the roles of the Chief Executive
      Officer and Chief Financial Officer.  As a result, the Company
      did not maintain adequate segregation of duties within our critical
      financial reporting applications, the related modules and financial
      reporting processes.


·
              Lack
      of periodic review of the value of real estate acquired through
      foreclosure.  These periodic reviews are necessary in the
      preparation of our financial statements.


·
              We
      mischaracterized certain transactions related to the pledging of real
      estate as collaterial for notes payable.  We had originally
      accounted for these transactions as
sales.





There can
be no guaranty that past or future steps taken to remediate these weaknesses
will be effective to prevent a misstatement of balance sheet and income
statement accounts and statements of cash flow in our interim or annual
financial statements.  Management is not aware of any instance in
which we failed to identify or resolve a control or disclosure matter or failed
to perform a timely and effective review, but the deficiencies described above
create the possibility that we may subsequently discover a control or disclosure
matter that would have been identified and resolved had these weaknesses not
existed.





During
the second quarter of 2008, we discovered that one of our investors wired funds
to us in 2006 for investment that may not have belonged to her.  The
related wire transaction report we received did not identify her as the
beneficiary of the wire and we confirmed the wire internally rather than by
contacting the sending institution.  Although we have since changed
the manner by which we confirm wires, there is no guarantee that the means by
which we confirm wires will prevent this situation from arising in the
future.  Additionally, although we believe that the incident described
above was the only such incident, the fact that we have previously confirmed
wires internally creates the risk that we may discover similar situations in the
future.  This incident and any others that we may discover could
subject us to litigation with respect to the funds received, which could have an
adverse impact on our financial condition and results of
operations.





For information about the steps taken
with respect to these weaknesses, see Item 9A of Part II of this
report.





We
recently entered into a Consent Order with the Maryland Securities
Division.





In March 2008, as part of its review of
our pending registration statement, the Maryland Securities Division informed us
that it was investigating the actions of a former Senior Vice President, Martin
Angeli, who allegedly misappropriated approximately $74,872 in checks from an
investor between 2004 and 2006 which she tendered to this Senior Vice President
for deposit into her investor account but which he instead deposited into his
personal accounts.  We first learned of a potential problem in
November 2006 when we were notified by another financial institution that checks
made payable to us had been deposited into the Senior Vice President’s account
at that institution.  The aggrieved investor also contacted us to
report the fact that her funds had not been credited to her account as
requested.  We discussed the matter with our former Senior Vice
President, who claimed that the transactions represented personal loans from the
investor.  The investor, however, rejects this claim.  In
July 2007, this former Senior Vice President was arrested and charged with
theft.  At that time, we became aware of additional facts relating to
this matter and we restricted the Senior Vice President’s duties and handling of
any investor funds.  On February 2, 2009, we deposited $95,532,
representing the missing funds with interest, into the aggrieved investor’s
account at KH Funding.




11




In connection with its investigation,
the Maryland Securities Division also determined that this former Senior Vice
President offered and sold our securities without being registered as an
issuer-agent as required by the Maryland Securities Act.





In addition to the foregoing, the
Maryland Securities Division has determined that certain of our recordkeeping
and other internal controls were inadequate and that these inadequacies may have
contributed to the $864,000 loss allegedly suffered by Samar Ghadry because of
the actions of our former Senior Vice President, as discussed above in the risk
factor entitled “We are subject to pending litigation the outcome of which could
have a material adverse impact on us”.





On November 6, 2008, without admitting
or denying any of the conclusions of law made therein, we entered into a Consent
Order with the Maryland Securities Division to finalize its
investigations.  The Consent Order provides that our former Senior
Vice President acted as an unregistered issuer-agent in violation of the
Maryland Securities Act and that we used him as such in violation of the
Maryland Securities Act.  The Consent Order also provides that we
violated the Maryland Securities Act by failing to disclose that we had
outstanding redemption requests that were more than 30 days past due (see the
risk factor above entitled, “We have failed to comply with
the terms of our outstanding notes and the underlying indenture”) in two of the
post-effective amendments to the registration statement to which this prospectus
forms a part that we filed with the Maryland Securities Division for review and
comment.  Under the Consent Order, we agreed to pay a civil penalty of
$100,000, of which $85,000 was waived due to our financial
condition.  The Consent Order also requires us to disclose in the
documents we file with the SEC certain record keeping and other internal control
issues described above and elsewhere in this prospectus, to keep the Maryland
Securities Division abreast of the status of our redemption payments, and to
retain an independent consultant to help us identify problems with and
strengthen our record keeping practices and our other internal controls and to
help us ensure compliance with the Indenture to which our investor notes
relate.





Our obligations under the Consent Order
will impose additional regulatory burdens on us, will require us to incur
additional consulting expenses, and may cause us to discover other weaknesses or
irregularities.





For further information about these
matters and the effects they have had or could have on our business, please see
the discussions in Item 7 of Part II of this report under the heading “Recent
Developments” and in Item 9A of Part II of this report.





A
change in market interest rates may reduce our profits and impair our ability to
repay our debt.





Rapid
changes, either upward or downward, in interest rates may adversely affect our
profits. Any future rise in interest rates may:





·
              reduce
      customer demand for our products;


·
              widen
      investor spread requirements;


·
              change
      loan prepayment rates;


·
              increase
      our cost of funds;


·
              reduce
      the spread between the rate of interest we receive on loans and interest
      rates we must pay under our Notes; and


·
              limit
      our access to borrowings in the capital
markets.




We are
subject to risks associated with decreases in interest rates because we have
issued fixed rate investor notes with scheduled maturities of over one year. At
December 31, 2008, we had $12.05 million of fixed rate investor notes with
scheduled maturities greater than one year.  If market interest rates
decrease in the future, the rates paid on our outstanding fixed rate investor
notes could exceed the current market rate paid on interest-earning
instruments.  There can be no guaranty that we will be able to
purchase or price interest-earning assets at levels sufficient to effectively
manage the risk associated with our interest-bearing
liabilities.  Accordingly, if the rates paid on our fixed-term,
fixed-rate investor notes exceed market rates and we are not able to effectively
manage these liabilities with earning assets, our profitability will likely be
reduced and our ability to repay our indebtedness, especially our investor
notes, could be adversely impacted.




12





Changes
in the economic conditions in our lending areas could have a material adverse
impact on our financial condition, the ability of our borrowers to repay their
loans and the value of the real estate and other collateral securing those
loans.





Any negative changes that arise in the
economy and/or real estate market of the areas in which we make and sell loans
could have a materially adverse impact on our net income, the ability of our
borrowers to make payments under their loans, and any recovery we can obtain by
proceeding against the collateral securing those loans, all of which would
reduce our ability to make pay our debts as they come due, including investor
note redemption requests.  We have made or purchased loans in
Washington, D.C., the Maryland counties of Anne Arundel County, Baltimore
County, Frederick County, Howard County, Montgomery County, and Prince Georges
County, and Baltimore City, Maryland.  The national and local real
estate economies have weakened during the past two years in part due to the
widely-reported problems in the sub-prime mortgage loan market.  As a
result, real estate values across the country have decreased and the general
availability of credit, especially credit to be secured by real estate, has also
decreased.  These conditions have made it more difficult for real
estate owners and owners of loans secured by real estate to sell their assets at
the times and at the prices they desire.  From 2006 to 2008, we have
observed an overall decrease in the median sales price for real estate in our
primary market areas of between 10% to 20%.  Generally, our mortgage
loans involve properties valued at less than $500,000, and these properties tend
to experience smaller declines when market prices deteriorate.





Our
assessment of the quality of loans we originate and acquire may be
inaccurate.





During
the last five years, approximately 80% of our new loans have been purchased
rather than originated by us.  Before we purchase or originate loans,
we perform an evaluation of the loans in order to determine whether they are
suitable for our portfolio. Our initial evaluation of the loans may be flawed
and actual results may be different than expected which, if unfavorable, could
adversely affect our financial condition and results of operations. The majority
of our loans, including those loans that are considered “sub-prime” loans, are
“hard collateral” loans.  A hard collateral loan is a loan in which
the loan amount is equal to or less than 70% of the value of the
collateral.  We underwrite these loans such that, if the borrowers
were to default, the underlying collateral should be adequate to cover both the
principal and interest due on the loan.  Nevertheless, in the future,
our loan loss percentage could increase, our assessment of collateral values may
be inaccurate, and/or collateral values may decrease due to changes in economic
or other conditions, any of which could adversely affect our
profitability.  See Item 1 of Part I of this report under the headings
“Lending Activities” and “Allowance for Loan Losses” for further
information.





Our
borrowers may fail to repay their loans.





Almost all of our income is generated
from our lending business.  Thus, the primary risk associated with our
business is that persons to whom we lend money will fail to repay their loans or
will fail to make timely payments to us.  In fact, as of December 31,
2007, one of our significant stockholders and her affiliate to whom we have made
loans were past due with respect to $5.7 million of collateralized loans, and
these loans were on the watch list.  However, all of these loans were
brought current by March 31, 2008.  We did not pursue collection of
these loans and did not renegotiate the terms of these loans, but rather we
charged and collected the default rate of interest while they remained past
due.  Over the years, we have had other loans with unrelated borrowers
which were in default where we chose to forbear collection.  We
consider numerous factors when deciding whether to call a loan or allow a
defaulting borrower to continue working through his or her problems while a loan
is in default, none of which is whether that borrower is a related
party.  The primary factors are the value of the collateral and the
amount of the debt, and the plan of the defaulting borrower to repay the
debt.  In addition, we consider the costs and burdens that would be
occasioned by calling the loan, such as bringing suit and/or foreclosing on
collateral.  Where, as in this situation, the value of the collateral
is deemed sufficient to cover the majority of the debt and the borrower presents
the Board of Directors with a reasonable plan to bring the loans current, we
attempt to work with our borrowers.  There can be no guarantee,
however, that our policy of periodically working with defaulting borrowers
rather than pursuing collection will not ultimately result in the need to pursue
collection or make it less likely that we will not ultimately realize a loss
with respect to these loans.





The risks relating to the ability of
our borrowers to repay their loans are discussed in more detail
below.  It is impossible to predict whether one of our borrowers will
default or what impact any one borrower’s default may have on our
business.





Some
of the loans we make and acquire are sub-prime loans, which generally have
higher delinquency and default rates than prime mortgage loans.




In the
last few years, we have increased our purchasing of loans originated by brokers,
banks and other lenders that are considered sub-prime loans and we may to
continue to expand this component of our operations in the future.  At
December 31, 2008, we held sub-prime loans in the amount of $3.24 million, or
8.61% of our total loans.  Sub-prime loans are loans made to persons
with weak credit records or reduced repayment capacities.  Sub-prime
mortgage loans generally have higher delinquency and default rates than mortgage
loans made to prime borrowers.  Delinquency interrupts the flow of
projected interest income from a mortgage loan, and default can ultimately lead
to a loss if the net realizable value of the real property securing the mortgage
loan is insufficient to cover the principal and interest due on the mortgage
loan.




13





Recently,
the sub-prime mortgage banking environment has experienced considerable strain
from rising delinquencies and liquidity pressures.  Several high
profile sub-prime mortgage lenders have failed.  The increased
scrutiny of the sub-prime lending market is one of the factors that have
impacted general market conditions, as well as several significant sub-prime
mortgage originators.





If real
estate values continue to decline and we experience significant loan defaults,
we may not be able to prevent or materially diminish an adverse affect on our
financial condition or results of operations.  If our underwriting and
collection policies and methods are insufficient to control our delinquency and
default risks and do not result in appropriate loan pricing, our business,
financial condition, liquidity and results of operations could be materially and
adversely impacted.  For information about the manner in which we
manage this risk, see Item 1 of Part I of this annual report under the heading
“Lending Operations”.





Our
allowance for loan losses may be insufficient.





We maintain an allowance for loan
losses, which is a reserve established through a provision for loan losses
charged to expense, that represents management’s estimate of probable losses
that have been incurred within the existing portfolio of loans. The allowance,
in the judgment of management, is necessary to reserve for estimated loan losses
and risks inherent in the loan portfolio. The level of the allowance reflects
management’s continuing evaluation of, among other things, general economic,
political and regulatory conditions, the type of loan being made, the
creditworthiness of the borrower over the term of the loan, the value and
marketability of the collateral for the loan, loan concentrations, our loan loss
experience, current loan portfolio quality. The determination of the appropriate
level of the allowance for loan losses inherently involves a high degree of
subjectivity and requires us to make significant estimates of current credit
risks and future trends all of which may undergo material changes. If
management’s assumptions and judgments prove to be incorrect and the allowance
for loan losses is inadequate to absorb future losses, our earnings and capital
could be significantly and adversely affected.  Although management
uses the best information available to make determinations with respect to the
allowance for loan losses, future adjustments may be necessary if economic
conditions differ substantially from the assumptions used or adverse
developments arise with respect to our non-performing or performing
loans.  Material additions to the allowance for loan losses would
result in a decrease in our net income and capital and could have a material
adverse effect on our financial condition.  For detailed information
about our allowance methodology, see Item 7 of Part II of this report under the
heading “Comparison of Operating Results for Years ended December 31, 2008 and
2007 - Provision for Loan Losses/Allowance for Loan Losses”.





Our
remedies for collecting on a defaulted loan may be inadequate.





We may
fail to collect funds from originated and acquired loans.  Our ability
to fully recover amounts due under the originated and acquired loans may be
adversely affected by, among other things:





·
              the
      financial failure of the borrowers;


·
              adverse
      changes in the values of the real estate or other property that are
      pledged to secure our loans;


·
              the
      purchase of fraudulent loans;


·
              misrepresentations
      by a broker, bank or other lender;


·
              third-party
      disputes; and


·
              third-party
      claims with respect to security
interests.




A default
could require us to seek enforcement of a borrower’s guaranty, which could prove
to be inadequate to fully collect the loans. Therefore, we may experience losses
on acquired or originated loans in the future. These potential future losses may
be significant, may vary from current estimates or historical results and could
exceed the amount of our reserves for loan losses.  We do not maintain
insurance covering such losses. In addition, the amount of provisions for loan
losses may be either greater or less than actual future write-offs of the loans
relating to these provisions. Any of these events could have a materially
adverse effect on our business.





As of
December 31, 2008, 19 of our loans, representing $4.29 million or 11.43% of
total loans, were in default and on non-accrual status.  Over the past
five years, the amount of loans, as a percentage of total loans, that were
deemed not recoverable at the time they were written off has been between 0.35%
and 1.38%.  There can be no assurance that we will experience
similarly low charge-off rates in any future period.




14





See
“Comparison of Operating Results for Years ended December 31, 2008 and 2007 –
Provision for Loan Losses/Allowance for Loan Losses” in Item 7 of Part II of
this report for further information about this risk.




Our
lending and investment activities are not diverse.





Our
operations primarily consist of, and our income is derived from, investing in
mortgage loans that we purchase from brokers, banks and other lenders and from
loans that we make to small businesses and individuals. In addition, we may from
time to time, when it is available, invest excess cash in investment grade debt
securities issued by financial companies that we hold for liquidity and
investment purposes.  At December 31, 2008, we had $0.22 million in
cash which we intend to use to fund operations rather than for investment
activities.  Further, we hold as investments many of the properties on
which we foreclose. Most of these properties are held as rental investments.
This lack of diversification, of investing only in loans, and to a lesser degree
in real estate and securities, increases our exposure to the risk of loss if a
substantial number of our loans become uncollectible. This increases the risk
that uncollectible loans could materially affect our financial
results.





Our
lending activities are concentrated in the Washington/Baltimore metropolitan
areas.





Our
success depends in large part on the general economic conditions of the
Baltimore-Washington metropolitan area. The local economic conditions in the
areas have a significant impact on the demand for our loans as well as the
ability of our customers to repay loans, the value of the collateral securing
loans and the stability of our funding sources. A significant decline in general
economic conditions, caused by inflation, recession, acts of terrorism, outbreak
of hostilities or other international or domestic occurrences, unemployment,
changes in securities markets or other factors could impact these local economic
conditions and, in turn, have a material adverse effect on our financial
condition and results of operations.





We
have not established a line of credit with any other lender to provide funds for
operations.





To fund our operations and to repay our
investor notes, we rely solely on our net income from operations and funds
received from investors who purchase our investor notes and, from time to time,
shares of our common stock.  We do not maintain any line of credit
with any lender and have no present intention of establishing such a line of
credit.  Accordingly, if our net income and other traditional sources
of funds are not sufficient to pay our debts and other obligations as they come
due, our operations, and thus our financial condition and results of operations,
could be materially and adversely impacted.




We
may not be able to sustain our historical levels of loan originations and
acquisitions.





It will
be necessary for us to continue adding loans to our investment portfolio because
we need to re-invest proceeds of loan payoffs and invest the additional capital
received from the sale of our Notes.  Our ability to sustain the level
of loan originations and purchases needed depends upon a variety of factors
outside our control, including:





·
              interest
      rates;


·
              economic
      conditions in our primary market area;


·
              decline
      in real estate values;


·
              competition;
      and


·
              regulatory
      restrictions.





We
may incur future debt.





Our
indebtedness could have important consequences to investors.  For
example, it could:





·
              increase
      our vulnerability to general adverse economic and industry
      conditions;


·
              limit
      our ability to obtain additional financing;


·
              require
      the dedication of a substantial portion of our cash flow from operations
      to the payment of principal and interest on our indebtedness, thereby
      reducing the availability of such cash flow to fund our growth strategy,
      working capital, capital expenditures and other general corporate
      purposes;


·
              increase
      our vulnerability to interest rate increases if future debt must be
      incurred at higher rates of interest than currently exist;


·
              limit
      our flexibility in planning for, or reacting to, changes in our business
      and the industry;


·
              place
      us at a competitive disadvantage relative to competitors with less debt;
      and


·
              make
      it difficult or impossible for us to pay the principal amount of the Notes
      at maturity.




15




We may
incur substantial additional debt in the future.  If new debt is added
to our current levels, the related risks described above would
intensify.




Our
one day demand notes with checking account privileges allow those investors to
redeem their investment with one day advance notice to KH Funding, which could
increase the volatility of our cash position from time to time.





The
holders of our one day demand notes are given the option to withdraw funds by
providing one day advance notice to us of their redemption request, or through
the use of a KH Funding-investor joint checking account provided through Bank of
America and other local banks. These redemption privileges necessitate that we
attempt to keep adequate cash reserves on hand to accommodate immediate
redemption requests and may cause us to suffer severe cash
fluctuations.  When our cash reserves are not deemed adequate to fund
potential redemptions, we must rely on our ability to quickly sell other assets,
such as loans and investment securities.  In an attempt to carefully
manage this potential risk, we have established “maximum balance” limits on the
amount of our one day demand notes that may be held by any one investor.
Generally, no one investor may hold more than an aggregate of $250,000 in one
day demand notes. We reserve the right to waive this maximum balance limit for
any investor after careful analysis of the facts and circumstances, including
our financial condition, the amount of demand notes that are outstanding, and
the amount and due dates of our outstanding term notes.  During the
last five years, we have waived this maximum investment limit with respect to 12
accounts, including for one investment totaling approximately $864,000 in 2006
made by the mother of one of our former Senior Vice Presidents.  These
maximum balance limits do not provide us complete protection from the
possibility of severe cash fluctuations. If we experience severe cash flow
fluctuations from operations, it could impair our ability to make principal and
interest payments on the Notes.





At
December 31, 2008, approximately $4.97 million of our one day demand notes were
outstanding and approximately $10.80 million of our thirty day demand notes were
outstanding.  At that same date, we had approximately $0.22 million of
cash and cash equivalents and approximately $16.04 million in investment
property loans and residential first mortgage loans that we believe could be
sold to satisfy redemption demands.  See Item 7 of Part II of this
report under the heading “Liquidity and Capital Resources” for a more detailed
discussion on our liquidity strategy.





Our
success is dependent in part on our senior management team.





As a
small company, our growth and success is dependent, in part, upon the continued
services and experience of our executive officers.  Accordingly, the
loss of the services of any of our officers could disrupt our operations or
delay the implementation of our strategies while we search for a
replacement.  We have no agreements with any of our executive officers
or our other employees that prohibit them from competing with us.  We
maintain “key person” life insurance only on Robert L. Harris.  Key
person life insurance is intended to cover financial losses that result from the
absence or loss of an indispensable employee.  Thus, any financial
difficulties we may face in the event of the death of any other member of our
executive team would not be covered by insurance.  Moreover, there can
be no guaranty that the insurance on the life of Mr. Harris would be sufficient
to cover all losses that might arise if Mr. Harris were to die.




Some
of our officers and directors have invested in our investor notes, which may
create conflicts of interest.





As of
December 31, 2008, our executive officers and directors held a total of $0.17
million of our senior secured investor notes that were issued in prior
offerings.  We expect that some of our officers, directors and
principal stockholders may participate in this offering.  Although the
Company has adopted a Code of Ethics that is intended to prevent our officers
from taking actions that could create conflicts of interest, these investments,
particularly in unsecured investor notes, may nevertheless create the
possibility for conflicts of interest in the event we experience financial
difficulties, as our directors and officers may be in a position to allocate
available cash as they see fit, including to satisfy obligations under our
unsecured investor notes, such as the Series 4 Notes, before satisfying our
other junior debt.





We
have loaned significant amounts of money to some of our officers, directors and
principal stockholders.





From time to time, in the ordinary
course of our business, we make loans to our officers, directors and principal
stockholders.  At December 31, 2008, we had 12 loans receivable
totaling $10.79 million, or 28.72% of all loans, to officers, directors and
family members of officers and directors, and principal stockholders and
entities controlled by a principal stockholders.  The rates earned on
these loans range from 5.99% to 12.5%, with an average weighted yield at
December 31, 2008 of 8.03%, compared to an average yield earned on our total
loans portfolio of 9.89% and 10.68% for the years ended December 31, 2008 and
2007, respectively.  Of these loans, two loans, or $ 0.45 million at
December 31, 2008, were uncollateralized bearing annual interest rates of
between 10.06% and 13.50%.  Six loans were made to a significant
stockholder and her affiliate with an aggregate balance due at December 31, 2008
of $10.19 million, of which $ .45 million is classified as unsecured, $ 5.93
million is secured by first or second mortgages on 10 apartment buildings in
Baltimore, Maryland, a first mortgage on a residential property in Woodbine,
Maryland, shares of KH Funding common stock and KH Funding investment accounts
owned by the borrowers, $224,830 is secured by shares of KH Funding common
stock, and $ 3.81 million is secured by a second lien on commercial property in
Langley Park, Maryland.  As of December 31, 2007, this stockholder and
her affiliate were past due with respect to $5.7 million of loans, and these
loans were on the watch list.  However, all of these loans were
brought current by March 31, 2008.  No guarantees can be made as to
the future financial condition of these borrowers or future changes in the
values of the collateral securing their loans.  Moreover, although the
Company has adopted a Code of Ethics that is intended to prevent our officers
from taking actions that could create conflicts of interest, these loan
transactions could create, or appear to create, potential conflicts of interest
which may not necessarily be resolved in our favor and could have a material
adverse effect on our business, operating results and financial
condition.  See Note A and Note N to the audited financial statements
presented elsewhere in this report for further information about these loan
concentrations.




16





We
may repurchase shares of our common stock, which would reduce our cash balances
and stockholders’ equity.





The Maryland General Corporation Law
permits a Maryland corporation, with the approval of its board of directors, to
repurchase outstanding shares of its common stock, so long as, after giving
effect to the repurchase, the corporation will be able to pay its indebtedness
as it becomes due in the normal course of business and the corporation’s total
assets will not be less than the sum of its total liabilities plus, unless the
charter permits otherwise, the amount that would be needed, if the corporation
were to be dissolved, to satisfy the preferential rights upon dissolution of
stockholders whose preferential rights on dissolution are superior to those of
the holders of common stock.  In the future, the Company may choose to
repurchase shares of common stock.  Even though repurchases are
subject to statutory limitations, they will reduce cash available for operations
and stockholders’ equity.  As of the date of this prospectus, we have
not adopted any formal stock repurchase plan and we have no present intention of
repurchasing any further stock from any stockholder.





Our
Board of Directors does not have a separately-designated compensation committee,
which may cause conflicts of interest with our directors and certain of our
officers.





Currently,
we do not have a compensation committee and do not have plans to form such a
committee. Our Board of Directors makes decisions regarding compensation,
including the compensation for directors and executive officers. Our Board of
Directors is not entirely comprised of independent members, and our Chief
Executive Officer, who also serves as our Chief Financial Officer, is a member
of the Board of Directors.  This situation may give rise to conflicts
of interests between KH Funding and our directors and certain of our officers,
which may not necessarily be resolved in our favor. This could have a material
adverse effect on our business, operating results and financial
condition.




Our
lending activities subject us to the risk of environmental
liabilities.





A
significant portion of our loan portfolio is secured by real property. During
the ordinary course of business, we may foreclose on and take title to
properties securing certain loans. In doing so, there is a risk that hazardous
or toxic substances could be found on these properties. If hazardous or toxic
substances are found, we may be liable for remediation costs, as well as for
personal injury and property damage. Environmental laws may require us to incur
substantial expenses and may materially reduce the affected property’s value or
limit our ability to use or sell the affected property. In addition, future laws
or more stringent interpretations or enforcement policies with respect to
existing laws may increase our exposure to environmental liability. Although we
have policies and procedures to perform an environmental review before
initiating any foreclosure action on real property, these reviews may not be
sufficient to detect all potential environmental hazards. The remediation costs
and any other financial liabilities associated with an environmental hazard
could have a material adverse effect on our financial condition and results of
operations.





Risks
Specific to Our Securities




Neither
the shares of our common stock nor our investor notes are insured against loss
by the FDIC or any governmental agency.





Neither
the Federal Deposit Insurance Corporation nor any other governmental or private
agency insures our common stock or our investor notes.  The repayment
of our investor notes is dependent solely upon our earnings, our working capital
and other sources of liquidity available to us.  If these sources of
repayment are inadequate, investors could lose their entire
investment.


17





We
do not set aside funds in a sinking fund to redeem our investor notes and must
rely on our revenues from operations and other sources for redemption.





We do not
contribute funds on a regular basis to a separate account, commonly known as a
sinking fund, to redeem our investor notes upon maturity. Accordingly, holders
of our investor notes must rely on our cash reserves, which we fund with
revenues from operations, and other sources of liquidity (such as saleable loans
and investment securities) for redemption.  Our ability to generate
revenues from operations in the future is subject to general economic,
financial, competitive, legislative, statutory and other factors that are beyond
our control.  Therefore, funds from these sources may not be
sufficient to meet our anticipated future operating expenditures and debt
repayment obligations as they become due.





The
holders of our one day demand notes are given the option to withdraw funds by
providing one day’s advance notice to us of their redemption request, or through
the use of a KH Funding-investor joint checking account provided through Bank of
America and other local banks. These redemption privileges necessitate that we
attempt to keep adequate cash reserves on hand to accommodate immediate
redemption requests and may cause the Company to suffer severe cash
fluctuations.  When our cash reserves are not deemed adequate to fund
potential redemptions, we must rely on our ability to quickly sell other assets,
such as loans and investment securities.  In an attempt to manage this
potential risk, we have established “maximum balance” limits on the amount of
our one day and thirty day demand notes that may be held by any one investor.
Generally, no one investor may hold more than an aggregate of $250,000 in one
day demand notes and no one investor may hold more than an aggregate of $500,000
in our thirty day demand notes. We reserve the right to waive these maximum
balance limits after careful analysis of the facts and circumstances, including
our financial condition, the amount of demand notes that are outstanding, and
the amount and due dates of our outstanding term notes.  During the
last five years, we have waived this maximum investment limit with respect to 12
accounts, including for one investment totaling approximately $864,000 in 2006
made by the mother of one of our former Senior Vice Presidents.  These
maximum balance limits do not provide complete protection from the possibility
of severe cash fluctuations or shortages.





If we were to experience a large number
of redemption requests in a short period of time and our cash reserves or
saleable assets were not sufficient to satisfy these requests, holders of our
investor notes would not be timely paid and could lose some or all of their
investments.  At December 31, 2008, approximately $4.97 million of our
one day demand notes were outstanding and approximately $10.80 million of our
thirty day demand notes were outstanding.  At that same date, we had
approximately $0.22 million of cash and cash equivalents and approximately
$16.04 million in investment property loans and residential first mortgage loans
that we believe could be sold to satisfy redemption demands.  See Item
7 of Part II of this report under the heading “Liquidity and Capital Resources”
for a more detailed discussion on our liquidity
strategy.





We
have the right to make a mandatory call of our investor notes.





We may
prepay the outstanding principal amount of our fixed term notes and demand notes
at any time without penalty or premium. If we do so, investors may not be able
to re-invest with us or elsewhere at comparable interest rates and therefore
earn less interest income than investors originally expected.





The
Indenture for our investor notes does not contain financial, capital or
operating covenants or impose limits on our borrowings.





The
Indenture for our investor notes does not require us to maintain specified
capital ratios or require us to meet financial or operating ratios such as debt
to total capital, fixed charge coverage or specified levels of earnings before
interest, taxes, depreciation and amortization. Although we seek to maintain
adequate capital and operating ratios, the Indenture does not limit our ability
to increase our debt levels through the issuance of additional investor notes or
otherwise so long as we are not in default of our payment obligations under the
Indenture.  If we incur debt beyond our ability to repay our debt,
investors may lose all or a portion of their investment in our
notes.




Our
Series 4 investor notes are unsecured and subordinate in right of repayment to
our Series 3 investor notes and any other senior debt we may incur.





Our
Series 4 investor Notes are unsecured obligations of KH Funding and are
subordinated to our Series 3 investor notes and any other senior debt we may
incur.  Senior debt includes any indebtedness incurred in connection
with our borrowings from a bank, trust company, insurance company, or from any
other institutional lender.  Indebtedness does not have to be
specifically designated as “senior debt” for it to constitute senior
debt.  As of December 31, 2008, we had no senior indebtedness other
than our Series 3 investor notes.  If we were to become insolvent, the
Series 3 investor notes and any other outstanding senior debt would have to be
paid in full prior to payment of Series 4 investor notes in our
liquidation.  As a result, there may not be adequate funds remaining
to pay the principal and interest on the Series 4 investor notes.




18





The
ability to liquidate our investor notes is limited because of transfer
restrictions and the lack of a trading market.





Our
outstanding investor notes may not be transferred without our prior written
consent.  In addition, there is no established trading market for our
investor notes.  Due to the contractual restrictions and the lack
of  market for the sale of our investor notes, which depends upon the
presence in the marketplace of both willing buyers and sellers at any given
time, there can be no assurance that investors will be able to sell investor
notes to third parties even if we consent to such a sale.





Investors
who purchase Notes for IRA or SEP accounts that we administer could suffer
materially adverse consequences if their purchases are determined to be
prohibited transactions.





As a
trustee, we accept and administer purchases of our Notes by certain kinds of
retirement plans, such as individual retirement accounts, or IRAs, and
Simplified Employee Pensions, or SEP-IRAs. IRA and SEP-IRA investors are
eligible to invest in any of our Series 3 or Series 4 Notes.





The
Internal Revenue Code (the “Code”) prohibits certain dealings between
“disqualified persons” and retirement plans. These “prohibited transactions” are
defined in Section 4975 of the Code. An IRA or SEP-IRA trustee and an IRA owner
or SEP-IRA owner are considered “disqualified persons” for these purposes. If a
prohibited transaction occurs, excise taxes, income taxes and loss of the IRA’s
tax-exempt status could result.





The
Employee Retirement Income Security Act of 1974 (“ERISA”) has similar rules
regulating “prohibited transactions” between “parties in interest” and
plans.  An IRA or SEP-IRA trustee and an IRA or SEP-IRA owner are
considered “parties in interest.”  Under ERISA, a plan fiduciary (such
as the IRA trustee) is responsible for allowing a prohibited transaction or for
dealing with plan assets in the fiduciary’s own interest.





Although
we believe that an investment in our investor notes is not a “prohibited
transaction,” we have not requested or received a legal opinion or IRS
determination of the circumstances associated with the purchase of our investor
notes by IRAs and SEP-IRAs, and whether purchase of our investor notes is
considered a “prohibited transaction” under the Code or
ERISA.  Investors should contact their own professional advisors
regarding this matter before making an investment decision.





ITEM
1B. UNRESOLVED STAFF COMMENTS





None.





ITEM 2.PROPERTIES




Werentoffice space from which
we operate our headquarters at 10801 Lockwood Drive, Suite 370, Silver Spring,
Maryland 20901.  In 2008, the annual rent for this office space was
$102,426, and the lease expires on October 31, 2015.  Management
believes that our properties are adequately insured.





The real
estate we own is generally acquired at foreclosure or through a deed-in-lieu of
foreclosure. The more expensive properties on which we foreclose are sold as
soon as possible. Generally, we rent out the lower and medium priced
single-family residential properties we acquire through foreclosure and continue
ownership for a short period. Often these properties have a rental value that is
high relative to its carrying value. If so, we have an opportunity to maximize
profits from an ultimate sale by finding a good tenant, making cosmetic and
appliance upgrades, and then selling the property for, hopefully, a higher
market value than may have been realized by a quick sale. In order to determine
the fair market value of a foreclosed property we obtain an appraisal from a
licensed real estate professional.




We
currently own residential real estate in the following areas:




·
              one
      property held for sale in Louisville, Mississippi;


·
              one
      property held for sale in Gainesville, Georgia;


·
              four
      properties held for sale in South Bend, Indiana;


·
              one
      rental property in Grand Prairie, Texas;


·
              one
      rental property and one property held for sale in Washington,
      DC;


·
              one
      rental property in Montgomery, Alabama;


·
              one
      rental property in Waco, Texas;


·
              two
      rental properties in Leander, Texas;


·
              one
      rental property and one property for sale in Greenwood, South Carolina;
      and




19




·
              four
      rental properties and four properties for sale in
  Maryland.





ITEM
3. LEGAL PROCEEDINGS




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





We are at
times, in the ordinary course of business, a party to legal actions normally
associated with a lending institution.




ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF
SECURITY HOLDERS




No
matters were submitted to a vote of the shareholders during the fourth quarter
of 2008.





PART II




ITEM
5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
ISSUER PURCHASES OF EQUITY SECURITIES




Market,
Holders and Dividends





As of March 15, 2009, there were 56
owners of record of our common stock holding 3,074,981 shares.  There
is no established trading market for the shares of our common stock, and
transactions are infrequent and privately negotiated by the buyer and seller in
each case.  Management cannot predict whether any market will develop
in the near future.  The following table sets forth, to the extent
known to us, the high and low sales prices for the shares of our common stock
for each quarterly period of 2007 and 2008.





2007
                
                
                2008High
                
                
                Low
                
                
                High
                
                
                LowFirst
      Quarter
                
                No
      sales
                
                
                $
                2.00
                
                
                $
                2.00Second
      Quarter
                
                $
                2.60
                
                
                $
                2.60
                
                
                No
      salesThird
      Quarter
                
                No
      sales
                
                
                No
      salesFourth
      Quarter
                
                No
      sales
                
                
                No
      sales





Cash dividends on shares of our common
stock are at the discretion of the Board of Directors, based upon such factors
as operating results, financial condition, capital adequacy, statutory
requirements, and stockholder return.  Accordingly, there can be no
assurance that dividends will be declared in the future.  The Board
suspended paying quarterly dividends after the second quarter of 2007 to
preserve capital.  The following table sets forth the dividends
declared on our common stock for each quarterly period in 2007 and 2008, stated
in cents per share.




20





2007
                
                
                2008First
      Quarter
                
                $
                0.02
                
                
                $
                -Second
      Quarter
                
                
                0.02
                
                
                
                -Third
      Quarter
                
                
                -
                
                
                
                -Fourth
      Quarter
                
                
                -
                
                
                
                -





Equity
Compensation Plan Information





The following table contains
information about these equity compensation plans as of December 31,
2008:





Plan
      Category
              
              Number
      of securities to be issued upon exercise of outstanding options, warrants,
      and rights
                (a)
              
              
              Weighted-average
      exercise price of outstanding options, warrants, and rights
                (b)
              
              
              Number
      of securities remaining available for future issuance under equity
      compensation plans (excluding securities reflected in
                column
      (a))
                (c)Equity
      compensation plans approved by security holders (1)
              
              
              80,000
              
              
              $
              3.18
              
              
              
              850,000Equity
      compensation plans not approved by security holders (2)
              
              
              161,250
              
              
              $
              2.00
              
              
              
              N/ATotal
              
              
              241,250
              
              
              $
              2.39
              
              
              
              850,000







(1)
            Securities
      were granted under our 2005 Equity Incentive Plan, which was approved by
      stockholders in 2005.


(2)
              Securities
      issued under compensation plans not approved by stockholders include stock
      options and common stock purchase warrants issued to employees and
      non-employees (such as directors, consultants, advisors, vendors,
      customers, suppliers and lenders) in exchange for services or other
      consideration provided to us.  Both stock options and warrants
      permit the recipient to purchase shares of our common stock upon the
      exercise of the option or warrant and the payment of the exercise prices
      specified in those grants.  These issuances were not made
      pursuant to any formal policy or plan, but instead were issued on such
      terms and conditions as the Board of Directors determined appropriate at
      the time of grant or sale.





Stock Repurchases




The
Company did not repurchase any shares of its common stock during the fourth
quarter of 2008.




21





ITEM
6. SELECTED FINANCIAL DATA





The
following table sets forth certain selected financial data for the five years
ended December 31, 2008 and is qualified in its entirety by the detailed
information and financial statements, including notes thereto, included
elsewhere in this annual report.





Year
      Ended December 31,2008
                  
                  
                  2007
                  
                  
                  2006
                  
                  
                  2005
                  
                  
                  2004Statement
      of Operations Data:Total
      Interest Income
                  
                  $
                  4,226,263
                  
                  
                  $
                  6,035,475
                  
                  
                  $
                  6,144,252
                  
                  
                  $
                  3,534,054
                  
                  
                  $
                  2,274,933Interest
      Expense
                  
                  
                  3,550,048
                  
                  
                  
                  4,338,073
                  
                  
                  
                  4,041,679
                  
                  
                  
                  2,412,360
                  
                  
                  
                  1,297,978Provision
      for Loan Losses
                  
                  
                  592,999
                  
                  
                  
                  510,185
                  
                  
                  
                  312,858
                  
                  
                  
                  251,048
                  
                  
                  
                  266,700Non-interest
      (Loss) Income
                  
                  
                  61,001
                  
                  
                  
                  (17,086
                  )
                  
                  
                  (78,307
                  )
                  
                  
                  101,078
                  
                  
                  
                  121,637Non-Interest
      Expense
                  
                  
                  1,281,740
                  
                  
                  
                  1,434,656
                  
                  
                  
                  1,550,840
                  
                  
                  
                  1,016,039
                  
                  
                  
                  929,365Net
      Income (Loss)
                  
                  
                  (1,137,523
                  )
                  
                  
                  (264,525
                  )
                  
                  
                  160,568
                  
                  
                  
                  (44,315
                  )
                  
                  
                  (97,473
                  )Per
      Common Share Data:Basic
      Earnings (Loss) Per Share(1)
                  
                  
                  (0.44
                  )
                  
                  
                  (0.10
                  )
                  
                  
                  0.06
                  
                  
                  
                  (0.02
                  )
                  
                  
                  (0.04
                  )Diluted
      Earnings (Loss) Per Share(1)(2)
                  
                  
                  (0.44
                  )
                  
                  
                  (0.10
                  )
                  
                  
                  0.06
                  
                  
                  
                  (0.02
                  )
                  
                  
                  (0.04
                  )Dividends
      per share (1)
                  
                  
                  -
                  
                  
                  
                  0.04
                  
                  
                  
                  0.08
                  
                  
                  
                  0.10
                  
                  
                  
                  0.15





(1)
            Shown
      in cents per share.(2)
            Shows
      the potentially dilutive effects of shares issuable under our stock option
      plan if the options are not anti-dilutive, shown in cents per
      share.




22






Year
      Ended December 31,2008
            
            
            2007
            
            
            2006
            
            
            2005
            
            
            2004Balance
      Sheet Data:Cash
      and marketable securities
            
            $
            221,463
            
            
            $
            95,622
            
            
            $
            4,404,162
            
            
            $
            7,177,851
            
            
            $
            3,328,093Loans
      less allowance for loan losses
            
            
            36,860,118
            
            
            
            47,885,190
            
            
            
            54,704,020
            
            
            
            40,678,941
            
            
            
            20,144,798Real
      estate owned
            
            
            4,731,443
            
            
            
            2,244,569
            
            
            
            1,139,664
            
            
            
            802,815
            
            
            
            709,973Other
      assets(1)
            
            
            3,034,334
            
            
            
            3,167,560
            
            
            
            3,077,855
            
            
            
            2,110,938
            
            
            
            2,039,085Total
      assets
            
            
            44,847,358
            
            
            
            53,392,939
            
            
            
            63,325,701
            
            
            
            50,770,545
            
            
            
            26,221,949Notes
      payable
            
            
            38,828,923
            
            
            
            51,219,963
            
            
            
            61,774,343
            
            
            
            49,681,335
            
            
            
            24,817,403Collateralized
      Notes and Loans Sold with Recourse
            
            
            6,133,480
            
            
            
            261,764
            
            
            
            -
            
            
            
            -
            
            
            
            107,248Other
      liabilities(2)
            
            
            267,085
            
            
            
            872,146
            
            
            
            133,044
            
            
            
            174,403
            
            
            
            101,446Total
      liabilities
            
            
            45,229,488
            
            
            
            52,353,873
            
            
            
            61,907,387
            
            
            
            49,855,738
            
            
            
            25,026,097Stockholders
      (deficit) equity
            
            
            (382,130
            )
            
            
            1,039,066
            
            
            
            1,418,314
            
            
            
            914,807
            
            
            
            1,195,852Other
      Financial Data:Return
      on average assets(3)
            
            
            (2.32
            %)
            
            
            (0.45
            %)
            
            
            0.28
            %
            
            
            (0.12
            %)
            
            
            (0.40
            %)Return
      on average equity(4)
            
            
            (346.31
            %)
            
            
            (0.22
            %)
            
            
            13.76
            %
            
            
            (4.20
            %)
            
            
            (6.77
            %)Stockholders’
      (deficit) equity to total assets (5)
            
            
            (.86
            %)
            
            
            1.95
            %
            
            
            2.04
            %
            
            
            1.81
            %
            
            
            4.56
            %Stockholders’
      (deficit) equity to loans outstanding (5)
            
            
            (1.03
            %)
            
            
            2.17
            %
            
            
            2.59
            %
            
            
            2.25
            %
            
            
            5.94
            %Loan
      Portfolio:Principal
      funded during period
            
            $
            1,974,931
            
            
            $
            12,412,719
            
            
            $
            40,285,035
            
            
            $
            37,727,240
            
            
            $
            12,841,741Principal
      received during period
            
            $
            9,918,020
            
            
            $
            16,911,098
            
            
            $
            26,060,326
            
            
            $
            16,733,748
            
            
            $
            8,005,490Average
      interest rate for period
            
            
            9.89
            %
            
            
            10.65
            %
            
            
            11.05
            %
            
            
            10.66
            %
            
            
            10.89
            %Loan
      charge-offs as a percent of total portfolio at end of
    period
            
            
            0.73
            %
            
            
            0.50
            %
            
            
            0.46
            %
            
            
            0.35
            %
            
            
            1.38
            %Investor
      Notes Payable:Sale
      of notes during period
            
            $
            762,439
            
            
            $
            2,321,330
            
            
            $
            106,101,789
            
            
            $
            120,110,831
            
            
            $
            49,008,102Redemption
      of notes during period
            
            $
            14,057,779
            
            
            $
            14,912,760
            
            
            $
            95,933,794
            
            
            $
            96,630,099
            
            
            $
            44,786,895Average
      interest expense rate
            
            
            6.67
            %
            
            
            7.09
            %
            
            
            6.53
            %
            
            
            6.03
            %
            
            
            5.69
            %







(1)
            Consists
      of the sum of the following:  accrued interest receivable,
      prepaid expenses, other receivables, investments—other, property and
      equipment-net, and other assets.


(2)
            Consists
      of the sum of the following: other loans payable, accounts payable and
      accrued payroll liabilities, long-term lease liability, and escrows and
      security deposits.


(3)
            Using
      average of beginning and ending balances for assets, and earnings for
      period (annualized).


(4)
            Using
      average of beginning and ending balances for equity, and earnings for
      period (annualized).


(5)
            Using
      year-end totals.





ITEM
7. MANAGEMENT’S
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS




Overview




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




23




We
emphasize the acquisition and direct origination of small commercial real estate
mortgage loans and investment property residential mortgage loans. We purchase
first and second residential mortgage loans nationwide from other lenders and
banks.  The demand for our loans and the loans we purchase is largely
dependent on the strength of the national and local real estate
markets.  Over the last 10 years, the demand for real estate and real
estate-secured credit has generally been very strong, and real estate sales
prices in many markets across the Country, including our primary market area—the
Baltimore-Washington corridor—rose steadily.  In the past two years,
however, these real estate markets, and, thus, the demand for credit secured by
real estate, have weakened significantly in large part due to the
widely-reported meltdown of the financial services
industry.  Accordingly, if the current real estate trend continues and
economic conditions do not start to improve, we may not be able to achieve the
level of operations or profits that we have realized in the years when the
market and economy were good.




Since 1990, over 1,300 investors have
purchased our investor notes. The note purchasers have been attracted primarily
through word-of-mouth referrals. The proceeds from the sale of our investor
notes are used for investment in real estate mortgage loans, business loans,
investment grade debt securities and real property and also to redeem
outstanding investor notes.  As discussed elsewhere in this annual
report, our ability to sell investor notes in our principal markets was very
limited during 2006, 2007 and 2008 due to the fact that the registration
statement we filed in June 2006 to sell notes was not effective in Maryland
until November 2008.  Our inability to secure an effective
registration of our investor notes significantly hampered our ability to raise
funds for operations outside of our regular operations income.





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





Recent
Developments





In January 2009, in an effort to
strengthen our capital position, we sold 500,000 shares of our common stock to
five accredited investors for an aggregate subscription price of
$500,000.  Each investor was also granted a five-year option to
purchase additional shares of common stock in an amount equal to 50% of the
initial shares purchased by the investor, at an exercise price of $1.00 per
share.  The initial shares and the options were issued in transactions
exempt from registration pursuant to Section 4(2) of the Securities Act of 1933,
as amended, and Securities Act Rule 506.





On November 6, 2008, without admitting
or denying any of the conclusions of law made therein, we entered into a Consent
Order to finalize investigations undertaken by the Maryland Securities
Division.  The material terms of the Consent Order are discussed above
in Item 1A of Part I of this report under the heading “We recently entered into
a Consent Order with the Maryland  Securities
Division”.  Pursuant to the Consent Order, the Maryland Securities
Division assessed a civil money penalty against us in the amount of $100,000,
but waived all but $15,000 of this penalty.





On November 6, 2008, we received a copy
of a complaint that was filed against us by Samar Ghadry in the Montgomery
County, Maryland Circuit Court pursuant to which she seeks compensatory damages
in the amount of approximately $864,000 and punitive damages in the amount of
$5.0 million.  This litigation is discussed in Item 3 of Part I of
this annual report.





Comparison of Financial Condition at December 31,
2008 and 2007




Assets. Total assets decreased
$8.55  million, or 16.01%, to $44.85 million at December 31, 2008,
from $53.39 million at December 31, 2007. The size of the gross loan portfolio
decreased to $36.86 million at December 31, 2008 from $47.89 million at December
31, 2007.  These
decreases resulted primarily from loan payoffs and the lack of loan
originations.  In addition, in January 2007 we were required by the
Maryland Securities Division to redeem an aggregate of $464,511 in investor
notes that were sold to unaccredited investors without
registration.





Non-performing
assets consist of non-accrual loans and real estate owned and held for sale.
Loans that are delinquent for more than 90 days are evaluated for collectibility
and placed in non-accrual status when management determines that future earnings
on the loans may be impaired. While in non-accrual status, collections on loans,
if any, are recorded as collection of loan principal and no interest is
recorded.




Loans in
non-accrual status totaled $4,043,791 and $510,697 at December 31, 2008 and
2007, respectively.  Interest income not recognized as a result of
placing loans on a non-accrual status was $ 239,277 during 2008 and $ 45,354
during 2007.




At December 31, 2008 and 2007, we had
loans of $10,006,949 and $5,002,259, respectively, which were more than 90 days
past due and for which we continue to accrue interest. Management believes that
all of the loans 90 days past-due which are still accruing interest are
adequately collateralized (based on recent appraisals), and management does not
anticipate the loss of principal or accrued interest receivable on these
loans.




24





Information
related to non-performing assets and accruing past due loans are as
follows:





2008
            
            
            2007Non-accrual
      loans
            
            $
            4,043,791
            
            
            $
            510,697Foreclosed
      real estate held for sale
            
            
            2,652,069
            
            
            
            1,568,655Total
      non-performing assets
            
            $
            6,695,860
            
            
            $
            2,079,352Ratio
      of non-performing assets to:Total
      loans and foreclosed assets
            
            
            16.95
            %
            
            
            4.20
            %Total
      assets
            
            
            14.93
            %
            
            
            3.89
            %Loans
      90 days or more past due and still accruing interest
            
            $
            10,006,949
            
            
            $
            5,002,259Ratio
      of loans 90 days or more past due and still accruing to:Total
      loans
            
            
            27.15
            %
            
            
            10.45
            %Total
      assets
            
            
            22.31
            %
            
            
            9.37
            %





Real
estate owned represents property acquired by foreclosure, deed in lieu of
foreclosure or purchase, and consists of rental and held for sale real estate.
At December 31, 2008 and 2007, we had held for sale real estate owned of
$2,652,069 and $1,568,655, respectively, which are considered non-performing
assets. At December 31, 2008 and 2007, we had real estate owned held as rental
property of $2,079,374 and $675,914, respectively.





Liabilities. Total
liabilities decreased $7.12 million, or 13.60%, to $45.23 million at December
31, 2008, from $52.35 million at December 31, 2007. The decrease was largely the
result of the redemption of outstanding investor notes in 2008.




Equity. Total stockholders’
equity decreased to ($322,130) in 2008 from $1,039,066 in 2007 due to the
current years’ loss of $1,137,523 and the repurchase of common shares in the
amount of $300,000.





Off-Balance Sheet
Arrangements.  We enter into off-balance sheet arrangements in
the normal course of our business. These arrangements consist primarily of our
lines-of-credit or draw-type loans.  At December 31, 2008 and December
31, 2007, we had $4.23 million and $6.30 million in loans of this
type.  The unused or unfunded amount on these types of loans totaled
$0.82 and $ 0.98 million at December 31, 2008 and December 31,
2007.




In addition to these credit
commitments, we have certain contractual obligations that are discussed below
under “Liquidity and Capital Resources”.





Comparison
of Operating Results for Years ended December 31, 2008 and 2007




The
average yield earned on loans receivable decreased to 9.89% for fiscal year 2008
from 10.65% for fiscal year 2007. The decrease was due primarily to the
increased payoffs of higher interest rate loans during the falling interest rate
environment of 2008.




The
average rate paid on investor notes decreased to 6.67% for fiscal year 2008 from
7.09% for fiscal year 2007. The net result was a decrease in net interest rate
spread, which was 3.22% for 2008 as compared to 3.56% in 2007.




Net Income (Loss). Net loss
for the year ended December 31, 2008 was $1,137,523, compared to net loss of
$264,525 for the year ended December 31, 2007.  The loss in 2008 was
due to a high rate of loan payoffs, combined with a high rate of investor
redemptions and our inability to raise capital by accepting investor
deposits.





Interest Income. Total
interest income was $4.23 million in 2008, compared to $6.04 million in 2007.
The decrease resulted primarily from a decrease in loans outstanding due to the
increased frequency of loan payoffs in 2008. The interest income for all periods
includes point and fee income, interest earned on bank investments and
marketable securities.




25





Interest Expense. Interest
expense was $3.55 million in 2008, compared to $4.34 million for 2007. The
decrease resulted from a decrease in our investor accounts due to
redemptions.  The interest expense includes fees paid to
broker-dealers who sold our investor notes.




Provision for Loan Losses/Allowance
for Loan Losses.  The provision for loan losses was $592,999 in
2008 and $510,185 in 2007.  Our non-accrual loans were $4,043,791 at
December 31, 2008 and $510,697 at December 31, 2007, and our foreclosed real
estate held for sale was $2,652,069 and $1,568,655 at those same respective
dates. Our allowance for loan losses was $659,242 at the end of 2008 and
$495,480 at the end of 2007. Relative to loan write-offs in 2008 of $429,236,
our provision for loan losses of $592,999 is about 138% of our
write-offs.




We maintain an allowance for loan
losses to absorb losses from the loan portfolio, which is based on management’s
continuing evaluation of the quality of the loan portfolio, assessment of
current economic conditions, diversification and size of the portfolio, adequacy
of the collateral, past and anticipated loss experience, and the amount of
non-performing loans.  The allowance is increased by corresponding
charges to provision for loan losses, and by recoveries of loans previously
written-off. Write-off of a loan decreases the allowance. 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.





The most
common known risk in the loan portfolio is a non-performing or impaired loan
(i.e., the loan is more
than 90 days late and the possibility of collection is remote). If we have
specific knowledge or some other reason to consider a loan impaired, management
reviews the loan to determine if an impairment loss is required. Collections on
the loan reduce the balance of the impaired asset.





If the
non-accrual loan begins performing again, then it is reclassified as a
performing asset and will accrue interest retroactively from the last date
interest had been previously accrued.





If the
impaired loan is only partially recovered, or if after all legal remedies have
been exhausted no recovery, or no additional recovery, is available, then the
un-recoverable portion is written off against the loan loss allowance and the
balance of the loan loss allowance is decreased by the amount of the loan being
written-off.





Our
historical loan loss experience is as follows:




Year
      Ended December 31,
            
            Average
              Total
      Loans
            
            
            Write-Offs
              Net
      of Recoveries
            
            
            Percent2004
            
            $
            17,676,284
            
            
            $
            244,389
            
            
            
            1.38
            %2005
            
            $
            32,473,227
            
            
            $
            114,568
            
            
            
            0.35
            %2006
            
            $
            49,784,567
            
            
            $
            230,495
            
            
            
            0.46
            %2007
            
            $
            51,330,764
            
            
            $
            466,860
            
            
            
            0.91
            %2008
            
            $
            42,372,653
            
            
            $
            429,236
            
            
            
            1.02
            %




Non-Interest Income (Loss). We had non-interest
income of $61,001 in 2008 and a non-interest loss of $17,086 in 2007. The income
in 2008 was due to rental income.




Non-Interest Expense.
Non-interest expense decreased to $1,281,740 in 2008 from $1,434,656 in 2007.
The decrease was primarily the result of reductions in salaries and
wages.





Income Taxes. KH Funding has
elected to be treated as a Subchapter S corporation under the Internal Revenue
Code and accordingly no income tax items appear in the financial statements. An
S Corporation is an IRS tax classification for a domestically owned corporation
with no more than 100 owners who have elected to pay taxes under Subchapter S of
the Internal Revenue Code. An S corporation receives the protection of the
corporate form, but is taxed like a partnership; it is exempt from the corporate
income tax, but its profits flow directly to the stockholders, where they are
taxed as personal income.




Liquidity
and Capital Resources





To make and acquire loans, to satisfy
redemption requests from holders of our investor notes and to otherwise fund
operations, we depend on the availability of cash and cash
equivalents.  During 2008, our primary sources of cash were principal
and interest payments on loans ($9.9 million), proceeds from other loans ($5.3
million), proceeds from collateralized Notes Payable ($1.01 million), rental
income (0.13 million), and the proceeds from the sale of investor notes ($.76
million).  For the year ended December 31, 2007, our primary sources
of cash were principal and interest payments on loans ($22.39 million), proceeds
from the sales of participation interests in loans ($0.26 million), rental
income ($0.07 million), and the proceeds from the sale of investor notes and
other short term borrowings ($3.02 million).




26





Although
we have used the net proceeds from our investor note offerings received in prior
years to fund new loans, during the past few years about 80% of the loans added
to our portfolio have been purchased. We intend to continue the expansion of
this wholesale component of our operations and have it be a major part of our
loan acquisition strategy.  This increased wholesale component should
enable us to expand our operations and increase our net profit with a limited
amount of additional personal 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.




Additionally,
we intend to increase our purchase of loans that have characteristics we believe
make them more attractive for purchase on the secondary market.  Such
characteristics include full documentation, higher credit scores and lower
debt-to-income ratios for the borrowers.  To increase our investment
and portfolio activity, we plan to identify and utilize additional brokers,
lenders and banks as sources for our loan acquisitions.





Holders of our one day demand investor
notes can request 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 redemption immediately after investment, but we are required to redeem
the note within 30 days after receiving the request.  All other types
of investor notes are redeemable upon maturity, or prior to maturity on 90 days
advance notice, subject to a penalty.  These features, along with our
maximum investment guidelines, were designed to provide us with ample time to
satisfy redemption requests.  Under the Indenture related to our
outstanding investor notes and the Notes, we will be in default if we fail to
satisfy a redemption request within 30 days of the date set for redemption,
unless we obtain a waiver from each of the note holders who have requested
redemption.  Upon a default, for so long as such default is
continuing, the Indenture Trustee and/or the holders of at least 25% of the
principal amount of our outstanding investor notes are permitted, but not
required, to accelerate the maturity of all outstanding notes and take other
actions permitted by the Indenture.  Such acceleration would likely
require us to liquidate the Company.  See the risk factor above
entitled “We have failed to comply with the terms of our outstanding notes and
the underlying indenture” for information about our past failures to timely
satisfy redemption requests and the rights of holders of our securities in the
event of a liquidation.





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.





Historically, we have attempted to hold
5% to 20% of our assets in cash and cash equivalents to fund redemptions of one
day demand notes, which has been sufficient for us to meet our obligations in
the past.  As stated elsewhere in this annual report, however, our
ability to sell our investor notes in our principal markets during 2006, 2007
and 2008 was very limited due to delays in registering the
offering.  Our cash and cash equivalents, which are the primary
sources of funds to pay interest on and redeem our investor notes, were
significantly impacted by this registration delay.  At December 31,
2008, cash and cash equivalents were $221,463, or 0.50% of total assets compared
to $95,622 at December 31, 2007.  Overall, our low cash balances are
due to the fact that redemptions of our investor notes during 2008 and 2007
exceeded sales of investor notes during those periods due to our limited ability
to sell investor notes.  See Note B and Note D to our audited
financial statements included elsewhere in this annual report for additional
information about our liquidity.





At December 31, 2008, we held more than
$16.04 million in residential and commercial mortgage loans that we believe
could be sold within a short period of time for the purpose of satisfying
investor note redemption requests.  Further, we held $5.71 million in
business line-of-credit loans and second lien loans at December 31, 2008, which
earn higher yields than the first trust loans and that we believe could also be
sold, although generally they take longer to sell and are sold at a
discount.  It should be noted, however, that the national and local
real estate economies have weakened during the past two years in part due to the
widely-reported problems in the sub-prime mortgage loan market.  These
problems have had the effect of decreasing the amount of credit that is
available to borrowers.  As a result, sellers of real estate and loans
secured by real estate have found it more difficult in recent years to sell
their assets at the times and at the prices they desire.





Because of these legal and market
factors, we may not be able to sell loans from our portfolio to meet redemption
requests within our 30-day grace period.




27





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





Although maturities and scheduled
amortization of loans and investments are predictable sources of funds, the sale
of investor notes, redemption requests, and mortgage loan prepayments are
unpredictable and are greatly influenced by interest rate trends, economic
conditions and competition.  Our one day demand notes are a major
cause of turnover in our cash positions.  During the years ended
December 31, 2008 and 2007, we received approximately $9.99 million and $17.09
million, respectively, in loan principal payments, which included unscheduled
prepayments and payments due at maturity.  For these same periods, we
paid approximately $14.05 million and $14.91 million, respectively, in net
investor note principal redemptions.





The table below illustrates the sales
of investor notes versus redemptions for the years indicated:





Year
            
            Notes
      Sold
            
            
            Notes
      Redeemed
            
            
            Percentage2004
            
            $
            49,008,102
            
            
            $
            44,786,895
            
            
            
            91.39
            %2005
            
            $
            120,110,831
            
            
            $
            96,630,099
            
            
            
            80.45
            %2006
            
            $
            106,101,789
            
            
            $
            95,933,794
            
            
            
            90.42
            %2007
            
            $
            2,321,330
            
            
            $
            14,912,760
            
            
            
            642.42
            %2008
            
            $
            762,439
            
            
            $
            14,057,779
            
            
            
            1,843.79
            %





At
December 31, 2008, we had outstanding one day demand notes of $4.97 million and
outstanding thirty day demand notes of $10.80 million.  The maturities
of our outstanding investor notes at December 31, 2008 are as
follows:





Series
      3 Demand Notes
            
            BalanceOne
      Day
            
            
            4,973,042Thirty
      Day
            
            
            10,800,291Series
      3 Fixed Term Notes:Due
      within 1 year
            
            
            8,474,218Due
      in 1 to 3 years
            
            
            5,777,566Due
      in 3 to 5 years
            
            
            5,970,205Series
      4 Fixed Term Notes:Due
      within 1 year
            
            
            1,159,680Due
      in 1 to 3 years
            
            
            327,331Due
      in 3 to 5 years
            
            
            1,372,491


Subtotal
            
            $
            38,854,824Unamortized
      brokerage costs
            
            
            (68,507
            )Total
      investor notes, net
            
            $
            38,786,317





We intend
to continue to expand our operations through future public offerings of investor
notes marketed by us and select, contracted broker-dealers and from the private
placement of our common stock.  We expect that we will be able to
attract more investors who are interested in our longer-term fixed rate investor
notes. We offer trust services for IRA accounts through our Trust Services
Department. We intend to expand these services and believe that IRA investors
generally look for investments of a longer-term nature, which complements our
preferred mode of investing.  We also intend to increase our capital
level as a percent of total assets through the private sale of stock from
time-to-time.  However, there is no assurance that such transactions
will occur.




Known
Trends, Events or Uncertainties




Impact of
Inflation and Interest Rates - Our financial statements and notes thereto,
presented elsewhere herein, have been prepared in accordance with U.S. generally
accepted accounting principles, 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 we make. Unlike typical industrial
companies, nearly all of our assets and liabilities are monetary in nature. As a
result, interest rates have a greater impact on our financial performance than
the effects of inflation generally have on the typical industrial
companies.





28




Critical
Accounting Policies




The SEC
has issued guidelines on the disclosure of critical accounting policies, which
are those policies that require application of management’s most difficult,
subjective or complex judgments, often as a result of the need to make estimates
about the effect of matters that are inherently uncertain and may change in
subsequent periods.




Our
significant accounting policies are disclosed in Note A to the audited financial
statements presented elsewhere in this report.  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 foreclosure is probable.




Allowance for Loan Losses. We
periodically evaluate the adequacy of the allowance for loan losses based on our
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 or assessments are inherently subjective and future adjustments to
the allowance may be necessary if economic or other 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.




Recent
Accounting Pronouncements




Pronouncements
Adopted




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





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





On October 10, 2008, the FASB
issued Staff Position ("FSP") No. 157-3, Determining the Fair Value of a
Financial Asset When the Market for That Asset Is Not Active. FSP 157-3
clarifies the application of SFAS 157 in a market that is not active and
provides an example to illustrate key considerations in determining the fair
value of a financial asset when the market for that financial asset is not
active. FSP 157-3 was effective immediately upon issuance, and includes prior
periods for which financial statements have not been issued.  The
adoption of this standard did not have a material impact on the Company’s
financial statements.




Pronouncements Issued But Not Yet
Effective




On November 5, 2007, the SEC
released Staff Accounting Bulletin (“SAB”) 109, Written Loan Commitments
Recorded at Fair Value Through Earnings. This SAB supersedes SAB 105 and
expresses the current view that, consistent with the guidance in SFAS
No. 156, Accounting for Servicing of Financial Assets—an amendment of FASB
Statement No. 140, and SFAS No. 159, The Fair Value Option for
Financial Assets and Financial Liabilities—Including an amendment of FASB
Statement No. 115, the expected net future cash flows related to the
associated servicing of the loan should be included in the measurement of all
written loan commitments that are accounted for at fair value through earnings.
Management has evaluated the effects of the rule and does not anticipate a
material impact on our financial statements.




29





In December 2007, the FASB issued SFAS
141, Revised 2007 (SFAS 141R), “Business Combinations.” SFAS
141R’s objective is to improve the relevance, representational faithfulness, and
comparability of the information that a reporting entity provides in its
financial reports about a business combination and its effects. SFAS 141R
applies prospectively to business combinations for which the acquisition date is
on or after December 15, 2008. We do not expect the implementation of SFAS 141R
to have a material impact on our financial statements.





In December 2007, the FASB issued SFAS
No. 160, Noncontrolling Interests in Consolidated Financial Statements—an
amendment of ARB No. 51. This statement amends ARB 51 to establish
accounting and reporting standards for the noncontrolling interest in a
subsidiary and for the deconsolidation of a subsidiary. It also amends certain
of ARB 51’s consolidation procedures for consistency with the requirements of
SFAS No. 141 (revised 2007), Business Combinations. This statement is
effective for fiscal years, and interim periods within those fiscal years,
beginning on or after December 15, 2008. Management does not anticipate the
adoption of this standard to have a material impact on our financial statements.





In March 2008, the FASB issued SFAS
No. 161, Disclosures about Derivative Instruments and Hedging Activities.
This statement requires enhanced disclosures in order to enable investors to
better understand the effects of derivative instruments and hedging activities
on an entity's financial position, financial performance, and cash flows. This
statement is effective for fiscal years and interim periods beginning after
November 15, 2008, with early application encouraged. Management does not
anticipate the adoption of this standard to have a material impact on the
disclosures to our financial statements.





In May 2008, the FASB issued FASB Staff
Position 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. Previous guidance
provided for accounting of this type of convertible debt instruments entirely as
debt. For instruments subject to the scope of FSP APB 14-1, higher interest
expense may result through the accretion of the discounted carrying value of the
convertible debt instruments to their face amount over their term. 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 notpermitted. As of December 31,
2008, we do not have any instruments outstanding that would be subject to FSP
APB 14-1, but any instruments that we may issue in the future will be
subject to this pronouncement.





ITEM 7A. QUANTITATIVE AND QUALITATIVE
DISCLOSURE ABOUT MARKET RISK





The Company is a “smaller reporting
company” and, as such, is not required to provide the information called for by
this item.




30





ITEM 8A. FINANCIAL STATEMENTS AND
SUPPLEMENTARY DATA








REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING
FIRM




Board of
Directors and Stockholders


KH
Funding Company


Silver
Spring, Maryland




We have
audited the accompanying balance sheets of KH Funding Company (the “Company”) as
of December 31, 2008 and 2007, and the related statements of operations, changes
in stockholders’ (deficit) equity and cash flows for the years then ended. These
financial statements are the responsibility of the Company’s management. Our
responsibility is to express an opinion on these financial statements based on
our audits.




We
conducted our audits in accordance with standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. The Company is not required to
have, nor were we engaged to perform, an audit of its internal control over
financial reporting.  Our audits included consideration of internal
control over financial reporting as a basis for designing audit procedures that
are appropriate in the circumstances, but not for the purposes of expressing an
opinion on the effectiveness of the Company’s internal control over financial
reporting. Accordingly, we express no such opinion. An audit also includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements, assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.




In our
opinion, the financial statements referred to above present fairly, in all
material respects, the financial position of the Company as of December 31, 2008
and 2007, and the results of its operations and cash flows for the years then
ended in conformity with accounting principles generally accepted in the United
States of America.





The
accompanying financial statements have been prepared assuming that the Company
will continue as a going concern.  As is more fully explained in Note
B to the financial statements, the Company has had recurring losses from
operations and has a stockholders’ deficit,
which raise substantial doubt about the Company’s ability to continue as a going
concern.  Additionally, as is more fully discussed in Note H, the
Company has not been able to meet the redemption requests of holders of its
investor notes in a timely manner.  Management’s plans regarding those
matters is also described in Note B.The accompanying
financial statements do not include any adjustments that might result from the
outcome of this uncertainty.




/s/
Stegman & Company




Baltimore,
Maryland


April 14,
2009




31




KH Funding Company


Balance
Sheets





December
      31,2008
              
              
              2007AssetsCash
              
              $
              221,463
              
              
              $
              95,622Investments
      available for saleNonmarketable
              
              
              -
              
              
              
              25,437Loans,
      less allowance for loan losses of (2008) $659,242 and
      (2007) $495,480
              
              
              36,860,118
              
              
              
              47,885,188Accrued
      interest receivable
              
              
              2,155,100
              
              
              
              2,668,649Other
      receivables
              
              
              542,718
              
              
              
              106,944Prepaid
      expenses
              
              
              219,458
              
              
              
              208,549Property
      and equipment-net
              
              
              101,070
              
              
              
              141,993Real
      estate ownedRental
      property
              
              
              2,079,374
              
              
              
              675,914Held
      for sale
              
              
              2,652,069
              
              
              
              1,568,655Other
      assets
              
              
              15,988
              
              
              
              15,988Total
      Assets
              
              $
              44,847,358
              
              
              $
              53,392,939Liabilities
      and Stockholders’ (Deficit) EquityLiabilitiesNotes
      and accrued interest payable
              
              $
              38,828,923
              
              
              $
              51,219,963Other
      loans payable
              
              
              92,408
              
              
              
              702,094Accounts
      payable and accrued expenses
              
              
              42,705
              
              
              
              32,827Escrows
      and security deposits
              
              
              81,115
              
              
              
              101,383Long
      term liabilities
              
              
              50,857
              
              
              
              35,842Loans
      sold with recourse
              
              
              4,454,698
              
              
              
              261,761Collateralized
      notes payable
              
              
              1,678,782
              
              
              
              -Total
      Liabilities
              
              
              45,229,488
              
              
              
              52,353,873Stockholders’
      (Deficit) EquityCommon
      stock (5,000,000 shares authorized; 2,574,981 shares (2008) and 2,724,981
      shares (2007), issued and outstanding;
      $0.01 par value)
              
              
              25,750
              
              
              
              27,250Paid-in
      capital
              
              
              1,448,738
              
              
              
              1,730,911Accumulated
      deficit
              
              
              (1,671,168
              )
              
              
              (533,645
              )Subscription
      note receivable
              
              
              (185,450
              )
              
              
              (185,450
              )Total
      Stockholders’ (Deficit) Equity
              
              
              (382,130
              )
              
              
              1,039,066Total
      Liabilities and Stockholders’ (Deficit) Equity
              
              $
              44,847,358
              
              
              $
              53,392,939




The
accompanying notes are an integral part of these statements.





32





KH Funding Company


Statements
of Operations




Years
      Ended December 31,2008
            
            
            2007Interest
      IncomeInterest
      and fees on loans
            
            $
            4,226,142
            
            
            $
            6,004,398Interest
      on bank accounts
            
            
            121
            
            
            
            5,810Interest
      on investments-marketable securities
            
            
            -
            
            
            
            25,267Total
      interest income
            
            
            4,226,263
            
            
            
            6,035,475Interest
      ExpenseInterest
      and fees on notes
            
            
            2,983,356
            
            
            
            4,144,889Interest
      on other loans
            
            
            162,043
            
            
            
            192,467Interest
      on collateralized notes payable and loans sold with
    recourse
            
            
            404,649
            
            
            
            717Total
      interest expense
            
            
            3,550,048
            
            
            
            4,338,073Net
      interest income
            
            
            676,215
            
            
            
            1,697,402Provision
      for Loan Losses
            
            
            592,999
            
            
            
            510,185Net
      interest income after provision for loan losses
            
            
            83,216
            
            
            
            1,187,217Non-interest
      (Loss) IncomeRental
      income
            
            
            131,058
            
            
            
            67,947Gain
      (loss) on sale of real estate owned
            
            
            2,579
            
            
            
            (20,736
            )Loss
      on sale of securities
            
            
            -
            
            
            
            (52,567
            )Write
      down of investment available for sale
            
            
            (25,437
            )
            
            
            (25,436
            )Write
      down of accounts receivable
            
            
            (58,545
            )Other
            
            
            11,346
            
            
            
            13,706Total
      non-interest (loss) income
            
            
            61,001
            
            
            
            (17,086
            )Non-interest
      ExpenseSalaries
      and wages
            
            
            330,058
            
            
            
            456,245Professional
      fees
            
            
            276,464
            
            
            
            206,773Offering
      costs
            
            
            135,067
            
            
            
            156,368Administration
            
            
            84,466
            
            
            
            104,865Real
      estate maintenance
            
            
            112,822
            
            
            
            170,161Insurance
            
            
            82,914
            
            
            
            77,033Depreciation
            
            
            64,922
            
            
            
            60,471Rent
            
            
            115,600
            
            
            
            115,164Bank
      Charges
            
            
            55,110
            
            
            
            48,723Stock
      based compensation
            
            
            16,327
            
            
            
            18,878Other
            
            
            7,990
            
            
            
            19,975Total
      non-interest expense
            
            
            1,281,740
            
            
            
            1,434,656Net
      Loss
            
            $
            (1,137,523
            )
            
            $
            (264,525
            )Basic
      loss per share
            
            $
            (0.44
            )
            
            $
            (0.10
            )Diluted
      loss per share
            
            $
            (0.44
            )
            
            $
            (0.10
            )Cash
      dividends paid per common share
            
            $
            -
            
            
            $
            0.04




The
accompanying notes are an integral part of these statements.




33




KH
Funding Company


Statements
of Changes in Stockholders’ (Deficit) Equity





Common
    Stock
            
            
            Paid-in
            
            
            Accumulated
            
            
            Subscription
      Note
            
            
            Accumulated
              Other
              Comprehensive
            
            
            Total
              Stockholders’
              (Deficit)Shares
            
            
            Amount
            
            
            Capital
            
            
            Deficit
            
            
            Receivable
            
            
            (Loss)
      Income
            
            
            EquityBalance
      at January 1, 2007
            
            
            2,726,951
            
            
            $
            27,269
            
            
            $
            1,879,783
            
            
            $
            (269,120
            )
            
            $
            (185,450
            )
            
            $
            (34,168
            )
            
            $
            1,418,314Additional
      Stock Sold
            
            
            330
            
            
            
            4
            
            
            
            856
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            860Stock
      Redemptions
            
            
            (2,300
            )
            
            
            (23
            )
            
            
            (4,577
            )
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (4,600
            )Stock
      Based Compensation Expense
            
            
            
            
            
            
            
            
            
            
            18,878
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            18,878Dividends
      Paid $0.04 per share
            
            
            
            
            
            
            
            
            
            
            (164,029
            )
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (164,029
            )Comprehensive
      LossNet
      loss for the year ended December 31, 2007
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (264,525
            )
            
            
            
            
            
            
            
            
            
            
            (264,525
            )Change
      in fair value of investments
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            34,168
            
            
            
            34,168Total
      Comprehensive Loss
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (230,357
            )Balance
      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
            
            
            
            
            
            
            
            
            
            
            16,327
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            16,327Comprehensive
      LossNet
      loss for the yearended
      December 31, 2008
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (1,137,523
            )
            
            
            
            
            
            
            
            
            
            
            (1,137,523
            )Change
      in fair value of investments
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            -
            
            
            
            -Total
      Comprehensive Loss
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (1,137,523
            )Balance
      at December 31, 2008
            
            
            2,574,981
            
            
            $
            25,750
            
            
            $
            1,448,738
            
            
            $
            (1,671,168
            )
            
            $
            (185,450
            )
            
            $
            -
            
            
            $
            (382,130
            )




The
accompanying notes are an integral part of these statements.





34





KH
Funding Company


Statements
of Cash Flows





For
      the years ended December 31,2008
            
            
            2007Cash
      from Operating Activities:Net
      loss
            
            $
            (1,137,523
            )
            
            $
            (264,525
            )Adjustments
      to reconcile net loss to net cash from operating
    activities:Depreciation
            
            
            64,922
            
            
            
            60,471Amortization
      of loan fees
            
            
            (29,215
            )
            
            
            (122,718
            )Provision
      for loan losses
            
            
            592,999
            
            
            
            510,185Share-based
      compensation expense
            
            
            16,328
            
            
            
            18,878Loss
      on sale of securities and property & equipment
            
            
            -
            
            
            
            52,567(Gain)
      loss on sale of real estate owned
            
            
            (2,579
            )
            
            
            20,736Write-down
      on real estate held for sale
            
            
            -
            
            
            
            60,000Recognized
      loss on impairment of investments
            
            
            25,437
            
            
            
            25,436Changes
      in operating assets and liabilities:Accrued
      late charges
            
            
            (24,232
            )
            
            
            (10,052
            )Prepaid
      expenses
            
            
            (32,496
            )
            
            
            907Interest
      receivable
            
            
            368,082
            
            
            
            (796,598
            )Interest
      payable (included in notes payable)
            
            
            1,515,757
            
            
            
            2,005,603Accounts
      payable and accrued expenses
            
            
            9,878
            
            
            
            32,237Decrease
      in prepaid offering costs
            
            
            21,586
            
            
            
            85,040Deferred
      loan origination costs
            
            
            13,801
            
            
            
            7,174Unamortized
      brokerage fees
            
            
            63,024
            
            
            
            31,448Long
      term liabilities
            
            
            15,015
            
            
            
            14,453Prepaid
      loan expenses
            
            
            103,189
            
            
            
            78,940Net
      Cash provided by Operating Activities
            
            
            1,583,973.
            
            
            
            1,810,182Cash
      Flows from Investing Activities:Principal
      repayments from borrowers
            
            
            9,918,020
            
            
            
            17,091,098Loans
      made to borrowers
            
            
            (1,974,131
            )
            
            
            (11,524,219
            )Purchase
      of loans
            
            
            -
            
            
            
            (888,500
            )Payments
      related to real estate owned (purchases and improvements)
            
            
            
            
            
            
            (11,135
            )Proceeds
      from sale of marketable securities and other investments
            
            
            -
            
            
            
            562,750Proceeds
      (payments)  for other receivables
            
            
            (17,206
            )
            
            
            594,085Purchase
      of property and equipment, net
            
            
            -
            
            
            
            (41,888
            )Proceeds
      from sale of real estate owned
            
            
            16,151
            
            
            
            485,258Net
      Cash Provided by Investing Activities
            
            
            7,942,834
            
            
            
            6,267,449Cash
      Flow from Financing Activities:Proceeds
      from investor notes
            
            
            762,439
            
            
            
            2,321,330Principal
      payments on investor notes
            
            
            (14,057,779
            )
            
            
            (14,912,760
            )Proceeds
      from Notes Payable with Collateral
            
            
            1,059,696Payments
      for Loans Sold with Recourse
            
            
            (500,000
            )Proceeds
      from Loans Sold with Recourse
            
            
            
            
            
            
            261,765Proceeds
      from other loans payable
            
            
            5,342,819
            
            
            
            24,643,643Payments
      on other loans payable
            
            
            (1,629,472
            )
            
            
            (23,941,549
            )Proceeds
      from sales of common stock
            
            
            
            
            
            
            860Payment
      of dividends
            
            
            -
            
            
            
            (164,029
            )Redemption
      of common stock
            
            
            (300,000
            )
            
            
            (4,600
            )Decrease  in
      escrow and security deposits payable
            
            
            (78,669
            )
            
            
            (9,682
            )Net
      Cash Used by Financing Activities
            
            
            (9,400,966
            )
            
            
            (11,805,022
            )Net
      Increase (Decrease) in Cash
            
            
            125,841
            
            
            
            (3,727,391
            )Cash Balance, beginning
      of year
            
            
            95,622
            
            
            
            3,823,013Cash Balance, end of
      year
            
            $
            221,463
            
            
            $
            95,622Supplemental
      cash flows information:Interest
      paid
            
            $
            2,034,290
            
            
            $
            4,030,905Transfer
      of loans to other real estate owned
            
            $
            2,608,687
            
            
            $
            1,676,922





The
accompanying notes are an integral part of these statements.




35





KH
Funding Company




Notes to
Financial Statements


For
the Years Ended December 31, 2007 and 2006




NOTE
A—SUMMARY OF SIGNIFICANT POLICIES




Nature
of Operation




KH
Funding Company (the “Company”, “we”, “us”, and “our”) operated as a general
partnership from its founding in December 1990 until July 1, 1994, at which date
it incorporated. The Company is an authorized mortgage lender in the State of
Maryland, and provides lending services in the Washington, DC and Baltimore, MD
metropolitan areas, primarily to small businesses and individuals and also
purchases mortgage loans nationwide. The lending services the Company provides
include originating, buying and selling loans and servicing its loans in
house.




Use
of Estimates in Preparing Financial Statements




In
preparing financial statements in conformity with U.S. generally accepted
accounting principles, 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
from those estimates.




Reclassification




Certain
amounts have been reclassified from prior years’ financial statements to conform
with the current year’s presentation.




Investments
Available for Sale




Most of
the Company’s investments are considered available for sale instruments and are
recorded in compliance with Statement of Financial Accounting Standards (SFAS)
No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” The
cost of securities sold is determined by the specific identification method.
Purchase premiums and discounts are recognized in interest income using the
interest method over the term of the securities. Net unrealized holding gains
and losses are reported as accumulated other comprehensive income, a separate
component of stockholders’ equity. Declines in the fair value of individual
available-for-sale securities below their cost that are other than temporary
result in a write-down of the individual security to its fair market value;
write-downs are reflected in earnings as a realized loss on available-for-sale
securities. Factors affecting the determination of whether an
other-than-temporary impairment has occurred include a downgrading of the
security by a rating agency, a significant deterioration in the financial
condition of the issuer, or that management would not have the intent or ability
to hold a security for a period of time sufficient to allow for any anticipated
recovery in fair value.




Loans
Receivable and Allowance for Loan Losses





Loans
receivable are stated as unpaid principal balance net of any discounts,
premiums, unamortized 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 based upon the 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
loan 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.
It also incurs direct costs when it acquires loans. These direct 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.





The
allowance for loan losses is increased for charges to income and decreased for
charge-offs (net of recoveries). Management’s periodic evaluation of the
adequacy of the allowance is based on the Company’s past loan loss experience,
known or inherent risks in the portfolio, adverse situations which may affect
the borrower’s ability to repay, the estimated value of underlying collateral
and current economic conditions. It is reasonably possible that the Company’s
allowance for loan losses could change in the near term.




36





The
allowance for loan losses is the result of an estimation done pursuant to either
Statement of Financial Accounting Standards (“SFAS”) No. 5, Accounting for Contingencies,
or SFAS No. 114, Accounting by
Creditors for Impairment of a Loan. The allowance consists of a
specifically allocated component and a general unallocated
component.





The
specific allowances are established in cases in which management has identified
significant conditions or circumstances related to a loan that leads management
to believe the probability that a loss may be incurred in an amount different
from the amount determined by general allowance calculation described
below.





The
general unallocated component of the allowance is calculated by applying loss
factors to corresponding categories of outstanding homogenous loans in an
attempt to reduce the difference between estimated losses inherent in the
portfolio and observed losses. The Company originates loans for various loan
categories to include 1st Trust
Real Estate, 2nd Trust
Real Estate, Investment, Business Assets, etc. Each category has a specific
percentage loss history for the past five years. Based on this percentage loss
history, the Company sets aside a similar percentage for the current balance of
loans by category. These percentages, quantified in dollar amounts, comprise our
general allowance for loan losses. Environmental factors are also considered in
the calculation but are not a material component of the allowance.





Loans
that are delinquent for more than three months are evaluated for collectibility
and placed in non-accrual status when management determines that future earnings
on that loan may be impaired. While in non-accrual status, collections on loans,
if any, are recorded as collection of loan principal and no interest is
recorded.




Impaired
Loans and Allowance for Loan Losses





Under the
provisions of SFAS Nos. 114 and 118, Accounting by Creditors for
Impairment of a Loan, a loan is considered impaired if it is probable
that the company will not collect all principal and interest payments according
to the loan’s contractual 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 loans principal balance. Interest income on the other nonaccrual loans is
recognized only to the extent of interest payments received.




Property
and Equipment




Property
and equipment are stated at cost and depreciated over the estimated useful lives
of three to seven years, primarily using the straight-line method for financial
statement purposes.







Real
Estate Owned




Real
estate owned represents property acquired by foreclosure, deed in lieu of
foreclosure or purchase and is initially recorded at the lower of cost or fair
market value at the date of acquisition. In order to determine the fair value,
we obtain an opinion of value from a licensed real estate professional. Costs
relating to the improvements of the property are capitalized. Holding costs are
charged to expense as incurred. Subsequent to the foreclosure the property is
advertised for rent or sale. Management makes the determination of whether to
hold, rent or to sell the property on a case-by-case basis. Buildings for rental
property are depreciated over 30.5 years. Real estate owned which is held for
sale is not depreciated. Impairment changes are recognized when the fair value
of the property falls below its carrying value.




Notes
Payable




We offer
several different types of investor notes to our investors.  Some
notes are sold directly by us and many are sold through brokers. When brokers
are involved, the Company pays brokerage fees which it capitalizes and amortizes
into interest expense over the life of related notes.




37




Income
Taxes




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




Loss
Per Share




Basic
loss per share is derived by dividing net income available to common
stockholders by the weighted-average number of common shares outstanding and
does not include the effect of any potentially dilutive common stock
equivalents. Diluted loss per share is derived by dividing net income by the
weighted-average number of shares outstanding, adjusted for the dilutive effect
of outstanding stock options. For purposes of this calculation, stock options to
purchase 241,250 shares of common stock have been excluded for both 2008 and
2007, respectively, as their effect would be anti-dilutive.





Year
      Ended December 31,2008
            
            
            2007Basic:Net
      loss (attributable to common stock)
            
            $
            (1,137,523
            )
            
            $
            (264,525
            )Average
      common shares outstanding
            
            
            2,574,981
            
            
            
            2,726,210Basic
      loss per share
            
            $
            (0.44
            )
            
            $
            (0.10
            )Diluted:Net
      loss (attributable to common stock)
            
            $
            (1,137,523
            )
            
            $
            (264,525
            )Average
      common shares outstanding
            
            
            2,574,981
            
            
            
            2,726,210Dilutive
      effect of stock options
            
            
            -
            
            
            
            -Average
      common shares outstanding – diluted
            
            
            2,574,981
            
            
            
            2,761,232Diluted
      loss per share
            
            $
            (0.44
            )
            
            $
            (0.10
            )




Stock
Based Compensation





Effective
January 1, 2006, the Company adopted the fair value recognition provisions of
SFAS No. 123 (revised 2004), Share-Based
Payment (“SFAS 123(R)”) using the prospective method as the
standard. Because the Company’s shares are not publicly traded, we used the
Minimum Value Method to value our stock-based compensation. Under that method,
we will recognize as compensation expense over the service (or vesting) period
of the grantees. In addition, at January 1, 2006, the adoption date of SFAS
123(R), the Company had no unvested options outstanding.





Prior to
January 1, 2006, the Company applied the intrinsic value method of accounting as
prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock
Issued to Employees (“APB 25”), with pro forma disclosure of the impact on net
income (loss) of using the fair value option expense recognition method. Under
the intrinsic value method, compensation cost is the excess, if any, of the
market price of the stock at the grant date over the option exercise price. In
the past it has been the Company’s policy to grant options to employees that
vest immediately and consequently, the entire expense, if recognized, would have
been recognized in the period granted. The valuation of the fair value option
expense was calculated under the original provisions of the original SFAS 123,
Accounting for Stock-Based Compensation, as described in out previous
filings.





Comprehensive
Loss




Comprehensive
loss includes all changes in stockholders’ equity during a period, except those
relating to investments by and distributions to stockholders. Our comprehensive
loss consists of net losses and unrealized gains and losses on investments
available-for-sale. Accumulated other comprehensive loss is displayed as a
separate component of stockholders’ equity.




NOTE
B – GOING CONCERN





The
accompanying financial statements have been prepared by management in accordance
with the accounting principles generally accepted in the United States of
America, which contemplate continuation of the Company as a going
concern.  However, the Company has had recurring losses from
operations and has a stockholders’ deficit, which raise substantial doubt about
the Company’s ability to continue as a going concern.




38





Between
May 2006 and November 2008, we were unable to sell any of our investor notes in
our market areas, including the State of Maryland (our location), because of
delays in obtaining an effective registration for an offering from the
Securities and Exchange Commission (the “SEC”) and the Securities Division of
the Office of Maryland Attorney General (“Maryland Securities
Division”).  This registration delay significantly hampered our
ability to raise funds.  Our registration was declared effective in
November 2008 and we have since been working to, and expect to continue to work
to, reinvigorate our broker relationships and their sales of our investor
notes.  We believe that our ability to sell our investor notes is
essential to our ability to continue as a going concern because proceeds
obtained in the past solely from sales of loans have not been sufficient to meet
our liquidity needs, which include not only making and acquiring loans and
funding operational expenses but also complying with the redemption terms of our
outstanding investor notes and the underlying indenture.  See Note H
for more discussion about our non-compliance with the terms of our outstanding
notes and the underlying indenture.





Since
November 2008, the Company has sold approximately $1.12 million in investor
notes.  No assurance can be made that we will be able to maintain or
increase this selling volume.  In fact, our current registration
statement will expire on April 30, 2009 and we may not thereafter offer or sell
our investor notes until we amend the registration statement to provide 2008
audited financial statements and that amendment is declared effective by our
securities regulators.  We may receive comments on such an amendment
from our securities regulators which will need to be addressed before it can be
declared effective.  Accordingly, no assurance can be given as to when
an amendment necessary to continue our selling efforts after April 30, 2009 will
be filed or declared effective.





The
Company has a stockholders’ deficit of 0.85% of total assets, which gives the
Company no equity margin against potential future losses.  In order to
raise the equity the Board of Directors voted in 2007 to suspend the payment of
dividends and management is diligently working currently to sell common stock to
investors.  In January 2009 the Company sold $500,000 in common stock
to five existing shareholders at a price of $1 per share.  Half of the
shares were sold through conversion of deposit accounts and half were sold
through the issuance of loan.  Each investor was also granted a five
year option to purchase additional shares of common stock equal to 50% of the
these additional shares purchased at $1 per share.





Management
plans to monitor its liquidity carefully in order to attempt to meet its
obligations as they become due.  In addition to the efforts outlined
above, when necessary management will sell loans and other assets, such as the
real estate owed to raise necessary funds.  In addition, management
may continue to obtain loans in which Company real estate owned will serve as
the collateral.





NOTE
C—LOANS RECEIVABLE




Loans
receivable consist of 121 collateralized loans and eight uncollateralized loans
for 2008, and 186 collateralized loans and eight uncollateralized loans for
2007. The loans receivable originate from various individuals and businesses
ranging in balance from $502 to $3,808,297 for 2008 and $1,199 to $3,648,645 for
2007, bearing interest rates ranging from 5.00% to 24% in 2008 and from 3.99% to
24% in 2007, with a weighted-average yield of 9.89% and 10.65%, respectively.
Uncollateralized loans constitute approximately 0.9% of the gross loan value at
December 31, 2008 and 2007.




Loan
origination fees received from borrowers are deferred and amortized into
interest income over the estimated average life of the loans under a method
which approximates the effective interest rate method. The unamortized loan
origination fees, which are included as a reduction to loans receivable balance,
were $37,568 and $57,670 at December 31, 2008 and 2007,
respectively.




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. Unamortized costs were $205,958 and $309,147 at December 31, 2008 and
2007, respectively.




The
Company incurs direct loan origination costs in its 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. Unamortized direct loan origination costs were $23,820 and
$37,621 at December 31, 2008 and 2007, respectively.




39







Loans
Receivable by Collateral Type




The
Company’s loans receivable portfolio at December 31 consists of the following
loans:





2008
            
            
            2007Primary
      Collateral Type
            
            Amount
            
            
            AmountResidential
      Real Estate
            
            $
            9,462,159
            
            
            $
            11,441,120Business
      Assets and Commercial Real Estate
            
            
            1,577,300
            
            
            
            3,049,002Investment
      Property
            
            
            23,049,958
            
            
            
            30,711,891Residential
      Real Estate Second Trust
            
            
            1,478,526
            
            
            
            750,253Other
      Assets (Auto, Stock)
            
            
            1,296,720
            
            
            
            1,719,596Other
      Loans (Over Equity, Medical and Unsecured)
            
            
            329,462
            
            
            
            417,008Total
      loans receivable, gross
            
            
            37,194,125
            
            
            
            48,088,870Unearned
      fees and other
            
            
            325,235
            
            
            
            291,798Less
      allowance for loan losses
            
            
            (659,242
            )
            
            
            (495,480
            )Total
      loans receivable, net
            
            $
            36,860,118
            
            
            $
            47,885,188




Loan
maturities as of December 31, 2008 are as follows:





Year
      Ending December 31,2009
            
            $
            23,863,5972010
            
            
            2,388,3122011
            
            
            4,118,1302012
            
            
            130,1542013
            
            
            84,7932014
      and thereafter
            
            
            6,609,139Total
      loans receivable, gross
            
            $
            37,194,125




The fair
value of the gross loans receivable is estimated to be $37,399,001 and
$48,397,430 at December 31, 2008 and 2007, respectively. These estimates are
based on discounted cash flows using the year end average interest for loans,
assuming a mid-year pay-off of such loan in the year due.




At
December 31, 2008, the Company had outstanding loan balances to one borrower and
its affiliated entities of $10,189,123 which represented 27.24% of loans
outstanding at that date. Management believes that this concentration is
adequately collateralized with first deeds of trust on related real
estate.




The
Company issues lines-of-credit or draw-type loans. At December 31, 2008, the
Company had $6.30 million in loans of this type. The unused or unfunded amount
on these types of loans totaled $ .98 million at that date. This amount
represents approved loan dollars which borrowers may use at their
discretion.







Analysis
of Loan Loss Reserves




Analysis
of the allowance for loan loss is as follows:





Year
      Ending December 31,
            
            2008
            
            
            2007Beginning
      balance
            
            $
            495,480
            
            
            $
            452,154Provision
      for loan losses
            
            
            592,999
            
            
            
            510,185Loans
      charged off
            
            
            (429,237
            )
            
            
            (466,859
            )Recovery
      of loans previously charged off
            
            
            -
            
            
            
            -Ending
      balance
            
            $
            659,242
            
            
            $
            495,480




Loans in
non-accrual status totaled $4,043,791 and $510,697 at December 31, 2008 and
2007, respectively.




40




At
December 31, 2008 and 2007, the Company had loans of $10,006,949 and $5,002,259,
respectively, which were more than 90 days late and for which the Company
continues to accrue interest. Management believes that these loans are
well-collateralized and that both the principal and the related accrued interest
are collectible.





12/31/08
            
            
            12/31/07Total
      recorded investment in impaired loans at the end of the
    period
            
            $
            4,043,791
            
            
            $
            510,697Amount
      of that recorded investment for which there is a related allowance for
      credit losses
            
            $
            1,691,398
            
            
            $
            510,697Amount
      of related allowance for credit losses associated with such
      investment
            
            $
            448,298
            
            
            $
            306,815Amount
      of that recorded investment for which there is no related allowance for
      credit losses
            
            $
            2,352,393
            
            
            $
            -





12/31/08
            
            
            12/31/07The
      average recorded investment in impaired loans during the
      period
            
            $
            2,949,641
            
            
            $
            581,296The
      related amount of interest income recognized within that period when the
      loans were impaired
            
            $
            -
            
            
            $
            -The
      amount of income recognized using a cash basis during the time within that
      period that the loan was impaired
            
            $
            -
            
            
            $
            -




NOTE
D—PROPERTY AND EQUIPMENT




Property
and equipment consists of the following as of December 31:





2008
            
            
            2007Furniture
      and equipment
            
            $
            84,335
            
            
            $
            84,335Automobiles
            
            
            61,516
            
            
            
            61,516Computer
      software
            
            
            101,022
            
            
            
            101,022Leasehold
      improvements
            
            
            18,813
            
            
            
            18,813Total
      property and equipment-cost
            
            
            265,686
            
            
            
            265,686Less:
      Accumulated depreciation
            
            
            164,616
            
            
            
            123,693Property
      and equipment – net
            
            $
            101,070
            
            
            $
            141,993




Depreciation
expense related to property and equipment for the years ended December 31, 2008
and 2007, totaled $40,923 and $43,314, respectively.





NOTE
E—REAL ESTATE OWNED




Real
estate owned currently consists of rental and held for sale real
estate.





2008
            
            
            2007Rental
      property:Buildings
            
            $
            1,184,727
            
            
            $
            436,269Less:
      Accumulated Depreciation
            
            
            69,446
            
            
            
            51,9101,115,281
            
            
            
            384,359Land-rental
      property
            
            
            964,093
            
            
            
            291,555Total
      rental
            
            $
            2,079,374
            
            
            $
            675,914Held
      for Sale:Buildings
            
            $
            2,071,819
            
            
            $
            1,065,405Land
            
            
            580,250
            
            
            
            503,250Total
      held for sale
            
            $
            2,652,069
            
            
            $
            1,568,655




Depreciation
expense related to rental property for the years ended December 31, 2008 and
2007 totaled $17,536 and $17,157 respectively.




41




NOTE
F—NOTES PAYABLE, INTEREST EXPENSE AND TYPES OF NOTES




Information
related to investor notes payable at December 31, 2008 and 2007 is as
follows:





2008
            
            
            2007Number
      of notes payable
            
            
            1,101
            
            
            
            1,345Highest
      balance
            
            $
            2,413,462
            
            
            $
            2,992,200Lowest
      balance
            
            $
            12
            
            
            $
            1Lowest
      interest rate
            
            
            4.5
            %
            
            
            5.25
            %Highest
      interest rate
            
            
            9.15
            %
            
            
            9.15
            %Weighted
      average interest rate
            
            
            6.67
            %
            
            
            7.26
            %Number
      of accounts greater than $100,000
            
            
            74
            
            
            
            106Value
      of accounts over $100,000
            
            $
            21,035,572
            
            
            $
            29,193,921




The
carrying values of the notes payable approximate their fair value.





The
maturity dates of the notes payable are as follows:





Year
      Ending December 31,2009
            
            $
            26,664,2652010
            
            
            4,941,8162011
            
            
            3,994,8062012
            
            
            3,056,7802013
            
            
            161,5552014
            
            
            78,208Subtotal
            
            $
            38,897,430Unamortized
      brokerage costs
            
            
            (68,507
            )Total
      Notes and accrued interest payable
            
            $
            38,828,923




The
maturity date is considered to be the date on which the note first becomes a
demand note. Included in the due in 2009 category is $4,973,042 on one-day
demand notes, which the investor can immediately withdraw and $10,800,291 that
requires a 30 days notice before withdrawal can be made.





The
Company has two classes of notes payable—Series 3 and 4 notes. Series 3 and 4
notes were offered and sold pursuant to registration statements filed by the
Company with the SEC. The Series 3 notes are senior to all other debt of the
Company and are secured with a priority lien on the assets of the Company. The
Series 4 are subordinate to the senior debt of the Company.




As of
December 31, 2008, notes payable outstanding by class of securities is as
follows:





Series
      III
            
            Publicly
      issued senior debt
            
            $
            36,037,928Series
      IV
            
            Publicly
      issued subordinated debt
            
            
            2,859,502Subtotal
            
            
            
            
            38,897,430Unamortized
      brokerage costs
            
            
            
            
            (68,507
            )Total
      Notes and accrued interest payable
            
            
            
            $
            38,828,923




The
Company’s notes are sold directly by the Company and through brokers. For those
notes sold through brokers, the Company pays brokerage fees which it capitalizes
and amortizes into interest expense over the life of the related notes. The
unamortized brokerage costs were $68,507 and $131,532 at December 31, 2008 and
2007, respectively.




For the
year ended December 31, 2008 and 2007, interest expense totaled $2,983,356 and
$4,144,889, respectively, and interest paid totaled $2,034,290 and $4,030,905,
respectively.




42




NOTE
G— LOAN PARTICIPATIONS SOLD WITH RECOURSE





The
Company entered into a loan participation agreement during 2007 pursuant to
which it sold a $261,764 participation interest, with monthly interest only
payments due to the participants.   During 2008, the Company
entered into four additional loan participation agreements totaling $4.36
million and paid down one existing participation agreement in the amount of
$50,000.  These agreements are made with recourse and there is limited
liability on the part of the participant.  Additionally, the loan is
due on demand if it defaults.  The details of the agreements are as
follows:





Loans
      Sold with Recourse




Interest
      Rate
                        
                        Date
      Due
                        
                        Participation
                          Balance
                        
                        Payment
      Terms12.50%
                        
                        10/24/2008
                        
                        $
                        211,764
                        
                        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
                        
                        
                        2,511,108
                        
                        Interest
      and principal payment monthly10.00%
                        
                        1/1/2011
                        
                        
                        391,826
                        
                        Interest
      and principal payment monthlyTotal
      Loans Sold with Recourse
                        
                        $
                        4,454,698







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 $211,764 liability on its
books as of December 31, 2008 related to this obligation.





NOTE
H— CONTINGENCY ARISING FROM INVESTOR NOTES





As of
March 31, 2009, the Company is more than thirty days delinquent on redemption
requests from note holders of approximately $3.28 million. The Company fell
behind in the redemption of investor notes in the fall of 2008 and has been
working to become current since November of 2008.





The
Company reports to the Trustee, Wells Fargo Bank, all accounts for which the
Company fails to make a redemption request within thirty days of the redemption
date.  These failures are reported within two (2) business days after
the thirty day grace period has expired.





The
Company reports quarterly to the State of Maryland, Division of Securities, the
same information as is reported to the Trustee.





NOTE
I—REGULATORY MATTER





Between
May 2006 and November 2008, the Company experienced delays in obtaining an
effective registration to sell its investor notes.  This delay
resulted from (i) an investigation instituted by the Maryland Securities
Division relating to the Company’s unregistered sale in 2006 of investor notes
from Maryland and (ii) reviews by the SEC and the Maryland Securities Division
of its 2006 registration statement and subsequent amendments and a resulting
second investigation by the Maryland Securities Division, which the Company was
required to address before the registration statement could be declared
effective.





In
connection with the first investigation, the Maryland Securities Division
required us to redeem an aggregate of $464,511.07 in investor notes that were
sold to unaccreditied investors, offer accredited investors the right to rescind
their purchases of investor notes and to enter into a Consent Order in December
2007 to finalize the matter.




43





On
November 6, 2008, without admitting or denying any of the conclusions of law
made therein, the Company entered into a Consent Order with the Maryland
Securities Division to finalize the second investigation.  The Consent
Order provides that the our former Vice President acted as an unregistered
issuer-agent in violation of the Maryland Securities Act and that the Company
used him as such in violation of the Maryland Securities Act.  The
Consent Order also provides that the Company violated the Maryland Securities
Act by failing to disclose that the Company had outstanding redemption requests
that were more than 30 days past due in two of the post-effective amendments to
the registration statement which were filed with the Maryland Securities
Division for review and comment.  Under the Consent Order, the Company
agreed to pay a civil penalty of $100,000, of which $85,000 was waived due to
the Company’s financial condition.  The Consent Order also required
the Company to disclose in the documents that it files with the SEC certain
record keeping and other internal control issues described in the Company’s
prospectus, to keep the Maryland Securities Division abreast of the status of
the Company’s redemption payments, and to retain an independent consultant to
help the Company identify problems with and strengthen its record keeping
practices and other areas of internal controls and help ensure compliance with
the indenture to which the investor notes relate.





NOTE
J—RELATED PARTY TRANSACTIONS




The
following related party transactions exist as of the dates shown
below:




·
                Included in loans receivable at
      December 31, 2008 and 2007 are 12 notes totaling $10,788,498 and 12 notes
      totaling $10,649,192, respectively, from officers, stockholders and a
      company controlled by a stockholder. The interest rates on these notes
      range from 5.99% to 12.5%.


·
              Included in the notes payable at
      December 31, 2008 and 2007 are 56 notes totaling $7,163,483 and 66 notes
      totaling $11,437,449, respectively, which are held by officers and
      stockholders. These notes were all issued at the rate in effect for the
      applicable term selected as of the date each note was
      issued.


·
              There is an interest-only demand
      loan of $185,450, shown in the equity section of the Balance Sheet as
      a contra-equity, made to the Company’s CEO for the purchase of 100,000
      shares of stock in the Company. The interest rate on this loan is 7%. The
      stock has a book value of about $0 and a fair value of about $100,000 as
      of December 31, 2008. At December 31, 2008 and 2007, there was no accrued
      interest receivable on this
loan.




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




Included
in the notes receivable listed above are five loans in the aggregate amount of
$10.19 million to a trust for the benefit of a significant stockholder. These
loans were made during the year ended December 31, 2006. The proceeds of these
loans were used to purchase real estate which serves as security for the loans.
The loans bear interest at 8% per annum and have some variable up-side features.
Additional interest is earned on certain loans if the rental income the borrower
receives from the property exceeds certain allowable expenses. In addition, upon
the sale of certain real property(ies) (or components thereof), the Company is
to receive one quarter or one-half, depending on the specific property, of any
gain after adjusting for certain costs and commissions. The loans do not have
any variable down-side features which would cause interest to be lower than the
stated rate on each loan. Under the terms of the loans any refinancing or sale
of the properties must be approved by the Company in advance. During the year
ended December 31, 2008, the Company recognized no additional interest from the
above loan features. The Company recognizes such additional interest earned
through variable up-side loan features only when the additional interest is
collected.







NOTE
K—WARRANTS, OPTIONS AND OTHER STOCK ISSUED




Stock
Option Plans




The
Company has granted stock options to employees, stockholders and directors.
Prior to 2006, all options granted vested on the day they were granted. All
options granted in 2006 were issued under the 2005 Equity Incentive Plan. These
options, which are incentive stock options, vest over three years in three equal
annual installments.




44




In 2007,
60,000 options expired and 170,000 options were forfeited by a former
employee.  The following table depicts option activity for the years
ended December 31, 2008 and 2007:





Number of
              Shares
            
            
            Weighted-Average
      Exercise Price
            
            
            Aggregate Intrinsic
      ValueOptions
      outstanding at January 1, 2007
            
            
            471,250
            
            
            $
            2.40Options
      granted-2007
            
            
            -
            
            
            
            -Options
      expired or forfeited -2007
            
            
            230,000
            
            
            
            2.41Options
      exercised-2007
            
            
            -
            
            
            
            -
            
            
            $
            -Options
      outstanding at December 31, 2007
            
            
            241,250
            
            
            
            2.39
            
            
            $
            -Options
      granted-2008
            
            
            -
            
            
            
            -Options
      expired or forfeited -2008
            
            
            -
            
            
            
            -Options
      exercised-2008
            
            
            -
            
            
            
            -Options
      outstanding at December 31, 2008
            
            
            241,250
            
            
            $
            2.39
            
            
            $
            -





At
December 31, 2008, 214,584 of the Company’s outstanding options were
exercisable. The weighted average exercise price of these options is $2.30 and
the weighted average remaining contractual life is 1.3 years. The remaining
26,666 stock options vest over a period of three years and will be fully vested
by July 11, 2009. The combined weighted average exercise price for the total
241,250 options outstanding at December 31, 2008 was $2.39. Options to purchase
80,000 shares were granted under the 2005 Incentive Stock Option Plan. All of
the other options outstanding were granted outside of any shareholder approved
Stock Option Plan of the Company.




A summary
of stock options outstanding and exercisable at December 31, 2008 by exercise
price is as follows:





Weighted
      AverageRemainingNumber
                        
                        Contractual
      Life
                        
                        NumberExercise
      Price
                        
                        Outstanding
                        
                        (
      in years)
                        
                        Exercisable$
                        2.00
                        
                        
                        
                        161,250
                        
                        
                        
                        .75
                        
                        
                        
                        161,250$
                        3.00
                        
                        
                        
                        30,000
                        
                        
                        
                        2.54
                        
                        
                        
                        20,000$
                        3.30
                        
                        
                        
                        50,000
                        
                        
                        
                        2.54
                        
                        
                        
                        33,334241,250
                        
                        
                        
                        
                        
                        
                        
                        214,584







No
options were granted during 2008 or 2007.





The fair
value of options granted was calculated using the Black-Scholes option pricing
model. The 150,000 options granted to employees in the year ended December 31,
2006, the last year that options were granted, vest ratably each year over a
three year period.
Seventy thousand of these options were forfeited during 2007. The options
vesting in 2008 and 2007 gave rise to a $16,327 and $18,878 charge to income in
these years, respectively. The amount of approximately $12,000 in future
compensation costs for options outstanding will need to be recognized as these
options vest in future periods. The weighted average and other assumptions used
in the Black-Scholes model were during the year ended December 31, 2006 were as
follows:





Dividend
      yield
            
            
            2.67%Weighted
      average volatility
            
            
            22.4%Weighted average risk-free interest
      rate
            
            
            5.03%Weighted
      average expected life in years
            
            5
      years




No stock
was granted during 2008 and 2007.




45






NOTE
L—NONLOAN COMMITMENTS AND CONTINGENCIES




Lease
Commitment




In
October 2005, the Company expanded its office facilities to approximately twice
the original size. A new 10-year lease, which
will     expire October 31, 2015, was signed at that
time. The following is a schedule by years of approximate future minimum
payments under the lease as of December 31, 2008:





Year
      Ending December 31,2009
            
            $
            106,5222010
            
            
            110,7842011
            
            
            115,2082012
            
            
            119,8222013
            
            
            124,616Thereafter
            
            
            241,164Total
            
            $
            818,116




Total
rent expense, including storage facilities, under operating leases totaled
$115,600 and $115,164 for the years ended December 31, 2008 and 2007,
respectively.




Legal
Contingencies





On
October 31, 2008, Samar Ghadry filed a complaint against the Company and several
other defendants alleging the misappropriation of approximately $864,000 by a
former Senior Vice President of KH Funding, Martin Angeli.  Ms. Ghadry
claims that Mr. Angeli sold certain of her securities and unlawfully kept some
of the proceeds.  The Company is  involved because Mr.
Angeli allegedly caused these funds to be wired to his mother’s investor account
at KH Funding and then to an account at another institution also owned by his
mother.  In her suit against us, Ms. Ghadry seeks the return of
$864,000 plus punitive damages in the amount of $5.0 million.  This
litigation could subject us to substantial legal expenses, and we cannot predict
the outcome of this litigation or its potential impact on us.  We have
insurance policies that we believe will cover up to $3.0 million of any
judgment, but there can be no guaranty that our insurance policies will cover
any of these claims.  No adjustment related to this lawsuit has been
recorded in the financial statements.





The
Company is, at times, in the ordinary course of business, a party to legal
actions normally associated with a lending institution.





NOTE
M—OFF BALANCE SHEET LOAN COMMITMENTS





Credit
commitments are agreements to make loans to borrowers in the ordinary course of
business. The Company does not have such agreements.  However, the
Company does make line-of-credit type loans, which enable borrowers to draw down
on their approved loans as needed. At December 31, 2008, the Company had $6.30
million in loans of this type. Loans of this type had unused or unfunded
approved amount of $.98 million at that date.





NOTE
N — TRUST ACTIVITIES




The
Company became a trustee of IRA accounts in February 2003. The IRA accounts are
self-directed.  A portion of the assets under the trust have been
invested in investor notes.  As a trustee, the Company is subject to
Section 1.408-2(e) of the Internal Revenue Code and is subject to reviews by IRS
examiners.  No such review occurred in 2004.  The Company
underwent a review in 2005 and is not aware of any issues resulting from such
review.





Year
      Ending December 31,
            
            2008
            
            
            2007Total
      Assets under Trust
            
            $
            6,592,846
            
            
            $
            7,516,324Portion
      of Assets Invested in KH Funding Notes Payable
            
            $
            5,923,607
            
            
            $
            7,041,324Portion
      of Assets Invested in Outside Investments
            
            $
            669,239
            
            
            $
            475,000




46


NOTE N — LOAN
CONCENTRATIONS




The
Company makes loans to a number of different business and individuals; however,
it does have a concentration of loans, directly or indirectly, with two of its
stockholders. At December 31, 2008, the Company had approximately $10.19
million, or 27.06%, of its loans and interest receivable directly or indirectly
with one stockholder or entities owned at least to some extent by that
stockholder. The Company also purchases loans from a company owned by another
stockholder.  At December 31, 2008, approximately $11.80 million, or
21%, of the Company’s loans and interest receivable were loans of this
type.  During 2007 and 2008, no loans were purchased from this source
due to the inability of the Company to sell its investor notes and the resulting
shortage of funds required to purchase loans.  As is mentioned in Note
H - Related Party Transactions, the above loans were consummated on
substantially the same terms, including interest rates and collateral, as those
prevailing for comparable transactions.





NOTE O — COLLATERALIZED NOTES
PAYABLE






The
Company borrows funds through the issuance of notes payable which are
collaterized by its other real estate owned.  The following table
lists the collaterized notes which were outstanding at December 31,
2008:





Interest
      rate
            
            Due
      Date
            
            Amount
      Owed
            
            Payment
      Terms7.50
            %
            6/25/2010
            
            $
            434,696
            
            Interest
      accrued with principal curtailments as requested10.00
            %
            6/1/2009
            
            
            207,000
            
            Balance
      at 3/31/09 $200,000 with monthly interest only payments due 1st
      of each month10.00
            %
            6/1/2009
            
            
            207,000
            
            Interest
      only payments due 1st
      of each month10.00
            %
            6/1/2009
            
            
            205,086
            
            Interest
      only payments due 1st
      of each month8.00
            %
            6/5/2009
            
            
            100,000
            
            Interest
      only payments due 1st
      of each month10.00
            %
            12/31/2009
            
            
            200,000
            
            Interest
      only payments due monthly10.00
            %
            12/31/2009
            
            
            125,000
            
            Interest
      only payments due monthly10.00
            %
            12/31/2009
            
            
            200,000
            
            Interest
      only payments due monthlyTotal
      Collaterized Notes Payable
            
            
            $
      1,678,782






For the
last three properties listed in the table above the Company has assigned the
deed to the properties to the note holders as if the property was sold to the
notes holders.  If the Company does not repay the underlying
collateralized note on these properties, the notes holder will be able to retain
the related properties.





NOTE
P—FAIR VALUE MEASUREMENTS





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





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






47




Impaired
Loans





The
Company does not record loans at fair value on a recurring basis, however, from
time to time, a loan is considered impaired and an allowance for loan loss is
established. Loans for which it is probable that payment of interest and
principle will not be made in accordance with the contractual terms of the loan
are considered impaired. Once a loan is identified as individually impaired,
management measures impairment in accordance with SFAS 114, “Accounting by
Creditors for Impairment of a Loan,” (SFAS 114). The fair value of impaired
loans is estimated using one of several methods, including the collateral value,
market value of similar debt, enterprise value, liquidation value and discounted
cash flows. Those impaired loans not requiring a specific allowance represents
loans for which the fair value of expected repayments or collateral exceed the
recorded investment in such loans. At December 31, 2008, substantially all of
the totally impaired loans were evaluated based upon the fair value of the
collateral. In accordance with SFAS 157, impaired loans where an allowance is
established based on the fair value of collateral require classification in the
fair value hierarchy. When the fair value of the collateral is based on an
observable market price or a current appraised value, the Company records the
loan as nonrecurring Level 2. When an appraised value is not available or
management determines the fair value of the collateral is further impaired below
the appraised value and there is no observable market price, the Company records
the loan as nonrecurring Level 3.





Assets
and Liabilities Recorded as Fair Value on a Nonrecurring Basis





We may be
required from time to time, to measure certain assets at fair value on a
nonrecurring basis in accordance with U.S. generally accepted accounting
principles. These include assets that are measured at the lower of cost or
market that were recognized at fair value below cost at December 31,
2008.  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
            
            $
            4,043,791
            
            
            
            $
            4,043,791Other
      Real Estate Owned - Held for sale
            
            $
            2,652,069
            
            
            
            $
            2,652,069Rental
      property
            
            $
            2,079,374
            
            
            
            $
            2,079,374





48








ITEM 9. CHANGES IN AND
DISAGREEMENTS WITH ACCOUNTANTS ONACCOUNTING AND
FINANCIAL DISCLOSURE




None.




ITEM 9A. CONTROLS AND
PROCEDURES.





The Company maintains disclosure
controls and procedures that are designed to ensure that information required to
be disclosed in the Company’s reports filed under the Exchange Act with the SEC,
such as this annual 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 the Company’s management,
including the Chief Executive Officer, who also serves as the Company’s Chief
Financial Officer (“CEO”), as appropriate, to allow for timely decisions
regarding required disclosure.  A control system, no matter how well
conceived and operated, can provide only reasonable, not absolute, assurance
that the objectives of the control system are met.  Further, the
design of a control system must reflect the fact that there are resource
constraints, and the benefits of controls must be considered relative to their
costs.  These inherent limitations include the realities that
judgments in decision-making can be faulty, and that breakdowns can occur
because of simple error or mistake.  Additionally, controls can be
circumvented by the individual acts of some persons, by collusion of two or more
people, or by management override of the control.  The design of any
system of controls also is based in part upon certain assumptions about the
likelihood of future events, and there can be no assurance that any design will
succeed in achieving its stated goals under all potential future conditions;
over time, control may become inadequate because of changes in conditions, or
the degree of compliance with the policies or procedures may
deteriorate.





An
evaluation of the effectiveness of these disclosure controls as of December 31,
2008 was carried out under the supervision and with the participation of the
Company’s management, including the CEO.  Based on that evaluation,
the Company’s management, including the CEO, has concluded that the Company’s
disclosure controls and procedures were not effective as of December 31, 2008
due to the material weaknesses in our internal control over financial reporting
as of December 31, 2008, as further described below.





During the fourth quarter of 2008, the
Company made the following changes in internal control over financial reporting
that have materially affected, or are reasonably likely to materially affect,
the Company’s internal control over financial reporting:  (i)
implementation of second person reviews of all activities associated with our
cash transactions; and (ii) implementation of heightened quality controls over
new investor note accounts.





As required by Section 404 of the
Sarbanes-Oxley Act of 2002, management has performed an evaluation and testing
of the Company’s internal control over financial reporting as of December 31,
2008.  Management’s report on the Company’s internal control over
financial reporting is included on the page that follows.




49





MANAGEMENT’S
REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING




The management of the Company is
responsible for establishing and maintaining adequate internal control over
financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the
Exchange Act.  The Company’s internal control over financial reporting
is designed to provide reasonable assurance regarding the reliability of
financial reporting and the preparation of financial statements for external
purposes in accordance with generally accepted accounting principles in the
United States of America. The Company’s internal control over financial
reporting includes those policies and procedures that:  (i) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the Company; (ii)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the Company are
being made only in accordance with authorizations of management and directors of
the Company; and (iii) provide reasonable assurance regarding prevention or
timely detection of unauthorized acquisition, use or disposition of the
Company’s assets that could have a material effect on the financial
statements.




This annual report on Form 10-K does
not include an attestation report of the Company’s independent registered public
accounting firm regarding internal control over financial reporting because
management’s report was not subject to attestation pursuant to temporary rules
of the SEC that permit the Company to provide only this management’s
report.




Because of its inherent limitations,
internal control over financial reporting may not prevent or detect
misstatements. Also, projections of any evaluation of effectiveness to future
periods are subject to the risk that controls may become inadequate because of
changes in conditions, or that the degree of compliance with the policies or
procedures may deteriorate.  A control system, no matter how well
designed and operated can provide only reasonable, but not absolute, assurance
that the control system’s objectives will be met.  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 cost.





Management assessed the effectiveness
of the Company’s internal control over financial reporting as of
December 31, 2008.  In making this assessment, management used
the criteria set forth by the Committee of Sponsoring Organizations of the
Treadway Commission in Internal Control-Integrated Framework (the “COSO
Framework”).  Based on its evaluation, management has concluded that
there are material weaknesses in our internal control over financial reporting
and that, accordingly, the Company’s internal control over financial reporting
was not effective as of December 31, 2008.





A “material weakness” is defined as a
deficiency or a combination of deficiencies, in internal control over financial
reporting such that there is a reasonable possibility that a material
misstatement of the annual or interim financial statements will not be prevented
or detected on a timely basis.  A “significant deficiency” is a
deficiency, or a combination of deficiencies, in internal control over financial
reporting that is less severe than a material weakness, yet important enough to
merit attention by those responsible for oversight of a company’s financial
reporting.





The material weaknesses relate to the
following:





·
              Lack
      of tangible audit trail, such as documentation, dates and signatures of
      the performance of control activities such as review of journal entries,
      reconciliation of accounts and valuation of collateral and
      properties.


·
              We
      had one person, Mr. Harris, performing the roles of the Chief Executive
      Officer and Chief Financial Officer.  As a result, the Company
      did not maintain adequate segregation of duties within our critical
      financial reporting applications, the related modules and financial
      reporting processes.


·
              Lack
      of periodic review of the value of real estate acquired through
      foreclosure.  These periodic reviews are necessary in the
      preparation of our financial statements.


·
              We
      mischaracterized certain transactions related to the pledging of real
      estate as collaterial for notes payable.  We had originally
      accounted for these transactions as
sales.





Management
has taken steps and continues to take steps to remediate these weaknesses, but
there can be no guaranty that these remedial steps will be effective to prevent
a misstatement of balance sheet and income statement accounts and statements of
cash flow in our interim or annual financial statements.  Management
is not aware of any instance in which we failed to identify or resolve a control
or disclosure matter or failed to perform a timely and effective review, but the
deficiencies described above create the possibility that we may subsequently
discover a control or disclosure matter that would have been identified and
resolved had these weaknesses not existed.





Management believes that the Company’s
operations are not overly complex and that, accordingly, the performance of the
CEO and CFO roles can be managed by a single person.  Moreover, the
Company’s current capital resources are limited, and the hiring of a separate
CFO would further limit these resources.  Nevertheless, the Company
intends to separate the CEO and CFO duties currently handled by Mr. Harris by
hiring a Chief Financial Officer once the Company has the means to do
so.




50





Even
though management is not aware of any instance in which the Company failed to
identify or resolve a control or disclosure matter or failed to perform a timely
and effective review, the deficiencies described above could result in a
misstatement of balance sheet and income statement accounts and statements of
cash flow in our interim or annual financial statements that would not be
prevented or detected.  Accordingly, management has determined that
these deficiencies constitute material weaknesses.





Notwithstanding
management’s assessment that our internal control over financial reporting was
not effective as of December 31, 2008, we believe that the financial statements
included in this annual report correctly present in all material respects our
financial position, results of operations and cash flows for the fiscal years
covered herein.





April 15,
2009




/s/
      Robert L. HarrisPresident,
      Chief Executive Officer, andChief
      Financial Officer
 51











ITEM
9B. OTHER INFORMATION.




None.





PART III




ITEM
10. DIRECTORS,
EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE




Directors
and Executive Officers





Our Board
of Directors is currently made up of four directors, who are elected to annual
terms and until their successors are elected and qualified.  On
February 13, 2008, one director, Dr. Mervyn Feldman, died.  The Board
has not yet decided whether to elect a replacement or eliminate the vacancy by
permanently reducing the number of directors to four.  Executive
officers are appointed by the Board of Directors on an annual basis and serve
until their successors have been duly elected and qualified. There are no family
relationships among any of our directors or executive officers.





The following table sets forth the
names, ages and positions of our current directors and executive
officers:





Name
            
            Age
            
            Position(s)Robert
      L. Harris
            
            59
            
            Chief
      Executive Officer, President, acting Chief Financial Officer and
      DirectorJames
      E. Parker
            
            60
            
            Vice
      PresidentLouise
      B. Sehman
            
            74
            
            SecretaryRonald
      L. Nicholson
            
            54
            
            Vice
      President-Accounts and Loan AdministrationJack
      H. Breskow
            
            79
            
            DirectorAlvin
      Shapiro
            
            77
            
            DirectorJeremiah
      P. Connor
            
            69
            
            Director




ROBERT L.
HARRIS, age 59, was a founder of KH Funding Company in 1990 when he also began
his service as Managing General Partner and then President. He has been the
President, Chief Executive Officer and a director of KH Funding since its
incorporation in 1994, and has served as interim Chief Financial Officer since
October 5, 2007.  Prior to founding KH Funding, Mr. Harris owned and
operated businesses and managed commercial and corporate real estate for various
firms in Maryland.  He attended the Citadel Military College and
Montgomery College.





JAMES E.
PARKER, age 60, joined KH Funding Company in 1997 and serves as Vice
President.  Mr. Parker’s duties include serving as our office manager
and providing accounting assistance.  Mr. Parker has served as the
Chief Financial Officer and Treasurer of KH Funding, as well as Vice President
of Investor Relations and Trust Services.  Mr. Parker was an assistant
controller of a lumber and supply company before joining us.  He
earned a Bachelor of Science from the University of Maryland.





LOUISE B.
SEHMAN, age 74, joined KH Funding Company in 1992. She currently serves as our
Corporate Secretary and handles various bookkeeping functions.  Ms.
Sehman was a payroll supervisor for a convenience store chain before joining us.
She attended the University of Maryland. Ms. Sehman retired as Chief Financial
Officer and Treasurer effective March 31, 2006.





RONALD L.
NICHOLSON, age 54, joined KH Funding Company in 1996. He currently serves as the
Vice President of Accounts and Loan Administration.  Mr. Nicholson’s
duties include periodically reviewing loan accounts to ensure that our borrowers
are complying with the conditions of their loans and assisting in the
underwriting of new loans.





JACK H.
BRESKOW, age 79, has served as a director of KH Funding Company since its
incorporation in 1994. Mr. Breskow has served as Secretary of Jack H. Breskow
and Associates, Ltd. since 1989, which provides business, estate and financial
planning services to its clients.  Since 1953, Mr. Breskow has also
served as a registered representative of Lincoln Financial Advisors Corporation,
a registered broker-dealer and investment adviser firm.  He is a
Certified Life Underwriter and Accredited Estate Planner.





ALVIN
SHAPIRO, age 77, has served as a director of KH Funding Company since 2005. Mr.
Shapiro has served as president of A & S Shapiro Pension Consultants,
Inc., a third-party administrator of business pension plans, since
1997.  Since 1973, Mr. Shapiro has also served as a registered
representative of Chapin Davis, Inc., a broker-dealer firm.  He holds
a Series 6 license and the insurance industry designations of CLU and
CHFC.  Mr. Shapiro received an MBA from John Hopkins University and a
Bachelor of Science Degree in Finance from American College.




52





JEREMIAH
P. CONNOR, age 69, has served as a director of KH Funding Company since 2005.
Mr. Connor is currently a partner of Connor & Assoc. CPA’s, P.C. and has
served with that firm since 1986.  Mr. Connor is a Certified Public
Accountant with over 35 years of accounting experience. Mr. Connor is a
distinguished member of state and national CPA organizations. He graduated with
a Bachelor of Commercial Science from Benjamin Franklin University.





The Board of Directors has a standing Audit Committee,
whose members are Messrs. Connor and Shapiro (Chairperson).  Until
January 16, 2008, Mr. Harris also served on the Audit Committee.  The
Audit Committee is responsible for reviewing the audit policy and program and
recommending any policy changes to the Board of Directors, and the appointing,
replacing, compensating, and overseeing the Company’s independent registered
public accounting firm each year.  The Audit Committee meets with the
external auditors, reviews all of our SEC filings, oversees our internal control
structure and reports to the Board of Directors on the
findings.  During 2008, the Audit Committee met four
times.  The Board has determined that each of Messrs. Connor and
Shapiro is an “audit committee financial expert” as that term is defined in Item
407 of the SEC’s Regulation S-K.





Since we
do not have a class of equity securities listed on a national securities
exchange, we are not required to have a nominating committee or a compensation
committee.  We currently believe that the Board as a whole can
adequately fulfill the responsibilities of a nominating committee and a
compensation committee.  Our independent directors review and approve
executive compensation policies and practices, review the salaries and the
bonuses of the officers, including the Chief Executive Officer and Chief
Financial Officer, and administer our stock option plan and other benefit plans.
Our Chief Executive Officer provides input on the salaries of our other
executive officers and employees.  Should the circumstances change,
the Board may choose to form one or both of these committees.





Code
of Ethics





Our Board of Directors has adopted a
Code of Ethics that applies to our executive officers, including our principal
executive officer and principal financial officer.  A copy of our Code
of Ethics is posted on our website,www.khfunding.com.  We intend to satisfy the
disclosure requirement under Form 8-K regarding an amendment to, or a waiver
from, a provision of our Code of Ethics by posting such amendment or waiver on
our website.





Compliance
with Section 16(a) of the Exchange Act.





Our equity securities are not
registered under the Exchange Act and, accordingly, our directors, executive
officers and significant stockholders are not required to file equity ownership
reports pursuant to Section 16(a) of the Exchange Act.





ITEM
11. EXECUTIVE
COMPENSATION




Executive
Compensation





The following table sets forth the
total remuneration for services in all capacities awarded to, earned by, or paid
to our President and Chief Executive Officer (the “named executive officer”) for
each of the last two completed fiscal years.  No other person who
served as an executive officer during 2008 earned total compensation in excess
of $100,000 for 2008 (or would have earned in excess of such amount had they
been an executive officer as of December 31, 2008).  We do not
maintain any non-equity incentive compensation, pension or other retirement, or
non-qualified deferred compensation plans for our executive
officers.




53





SUMMARY
COMPENSATION TABLE






Name
      and principal position
              
              Year
              
              Salary
                ($)(1)
              
              
              Bonus
                ($)
              
              
              Stock
      Awards
                ($)
      (2)
              
              
              Option
      Awards
                ($)
      (2)
              
              
              All
      Other Compensation
                ($)
              
              
              Total
                ($)Robert
      L. Harris,
                President/CEO/CFO
              
              2007
              
              
              132,291
              
              
              
              2,283
              
              
              
              -
              
              
              
              8,916
              
              
              
              -
              
              
              
              143,4902008
              
              
              123,900
              
              
              
              -
              
              
              
              -
              
              
              
              8,916
              
              
              
              -
              
              
              
              132,816





(1)
            Mr.
      Harris also serves as a director of KH Funding for which he is entitled to
      receive standard director compensation as discussed
      below.  However, he did not accept any director compensation in
      2008 or 2007.  Director fees earned or paid in cash would be
      reported in the “Salary” column.


(2)
            The Company calculates the value
      of stock and option awards using the provisions of SFAS
      123(R).  See Note A and Note K to the audited financial
      statements presented elsewhere in this report regarding assumptions
      underlying valuation of equity
awards.





Employment
Arrangements





Executive officers are employed on an
at-will basis and are not parties to any written employment
agreement.  Our employment arrangements entitle the executive, while
employed, to an annual salary and participation in the bonus, equity and other
plans discussed above, as well as health, dental and life insurance programs in
place for executives from time to time.  For 2009, Mr. Harris is
entitled to an annual salary of $123,900.





Bonus
Program





All of our employees, including Mr.
Harris, are entitled to an annual bonus equal to one-half of one week’s pay,
based on their salary levels for that year.  No bonuses were taken in
2008.





Equity
Compensation Plans





We maintain two equity compensation
plans for executive officers and employees:  (i) the 1998 Stock and
Incentive Plan; and (ii) the 2005 Equity Incentive Plan.





The 1998 Stock and Incentive Plan was
approved by the Board of Directors and its stockholders in 1998 and was replaced
by the 2005 Equity Incentive Plan.  The plan provided for the grant of
incentive stock options, non-qualified stock options, stock appreciation rights,
restricted stock, restricted stock units and/or performance units to key
employees designated by the Board or its designated committee.  Awards
vested, were exercisable and terminated in accordance with the individual terms
of the award agreements granting such awards.  Awards could be payable
in shares of our common stock, cash, or other securities, as determined by the
Board and set forth in the award agreement.  Awards were subject to
adjustment and acceleration of vesting under certain specified
conditions.





The 2005 Equity Incentive Plan was
approved by the Board of Directors and our stockholders in 2005 and expires on
January 27, 2015.  The plan provides for the grant of incentive stock
options to our officers and employees, and non-qualified stock options, stock
bonus grants and/or restricted stock purchase grants to directors, officers,
employees and consultants.  Awards vest, are exercisable and terminate
in accordance with the individual terms of the award agreements granting such
awards.  Awards are payable in shares of our common
stock.  Awards are subject to adjustment and acceleration of vesting
under certain specified conditions.  At adoption, we reserved
1,000,000 shares of common stock for future issuances under this
plan.




54





The following table sets forth for the
named executive officer certain information about equity awards under all plans
that remained unexercised at December 31, 2008:





OUTSTANDING
      EQUITY AWARDS AT FISCAL YEAR-ENDOPTION
      AWARDSName
            
            Number
      of Securities Underlying Unexercised Options (#)
    Exercisable
            
            
            Number
      of Securities Underlying Unexercised Options
              (#)
              Unexercisable
      (1)
            
            
            Option
      Exercise Price
              ($)
            
            Option
      Expiration DateRobert
      Harris
            
            
            150,000
            
            
            
            -
            
            
            
            2.00
            
            9/30/200933,334
            
            
            
            16,666
            
            
            
            3.30
            
            7/10/2011





(1)
            The
      option vests in two equal installments on July 10, 2008 and July 10, 2009,
      respectively.





Director
Compensation





The following table provides
information about compensation paid to or earned by persons (other than Mr.
Harris) who served as directors of the Company during 2008.





Name
            
            Fees
      earned or
              paid
      in cash
              ($)
            
            
            Stock
      awards
              ($)(1)(2)
            
            
            Option
      awards
              ($)(1)(2)
            
            
            All
              other
              compensation
              ($)(3)
            
            
            Total
      ($)Jack
      H. Breskow
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            -
            
            
            
            -Dr.
      Mervyn Feldman
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            -
            
            
            
            -Alvin
      Shapiro
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            -
            
            
            
            -Jeremiah
      P. Connor
            
            
            2,983
            
            
            
            -
            
            
            
            -
            
            
            
            1,332
            (3)
            
            
            4,315





(1)
            Amounts
      reflect the dollar amounts recognized for financial statement reporting
      purposes in accordance with FASB 123(R).


(2)
            At
      December 31, 2008, no director held any outstanding stock awards or stock
      options.


(3)
            Amount
      reflects charges for consulting services provided by Mr.
      Connor.





The
Company pays Mr. Connor $250 per hour for serving on the Board of
Directors.  All other directors waived directors’ fees in
2008.




55





ITEM
12. SECURITY
OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER
MATTERS




The
following table sets forth, to the best of our knowledge, information as of
December 31, 2008 relating to the beneficial ownership of our common stock by
(i) each person or group known by us to own beneficially more than five (5%) of
the outstanding shares of our common stock; (ii) each of our directors, director
nominees, and named executive officers (as defined below); and (iii) all of our
directors and executive officers as a group, and includes all shares of our
common stock that may be acquired within 60 days of December 31,
2008.  The address of each of the persons named below is the address
of KH Funding except as otherwise indicated.  Such beneficial
ownership includes securities owned by or for the spouse, children or certain
other relatives of the identified persons as well as other securities as to
which the person has or shares voting or investment power.  The same
shares may be beneficially owned by more than one person.





Name
                  
                  Number of
      Shares
                  
                  Percent
      of
                    Class
      as of
                    December
      31,
                    2008Directors
      and Named Executive OfficersRobert
      L. Harris, President, CEO and Director
                  
                  
                  515,000
                  (1)
                  18.29
                  %Jack
      H. Breskow, Director
                  
                  
                  39,700
                  (2)
                  1.41
                  %Jeremiah
      P. Connor, Director
                  
                  
                  -
                  
                  -Alvin
      Shapiro, Director
                  
                  
                  600
                  
                  0.02
                  %All
      Directors and Executive Officers as a Group (7 persons)
                  
                  
                  555,300
                  (3)
                  19.72
                  %5%
      StockholdersSolomon
      Kaspi
                    267
      Kentlands Blvd. Gaithersburg, MD 20878
                  
                  
                  167,168
                  
                  5.94
                  %Christine
      Nuyen
                    267
      Kentlands Blvd, Gaithersburg, MD 20878
                  
                  
                  166,666
                  
                  5.92
                  %Carlos
      Saenz
                    267
      Kentlands Blvd, Gaithersburg, MD 20878
                  
                  
                  166,666
                  
                  5.92
                  %Richard
      Allen
                    7224
      Armat Drive, Bethesda, MD 20817
                  
                  
                  165,000
                  
                  5.86
                  %Douglas
      Kelly
                    11120
      Arroyo Drive, Rockville, MD 20852
                  
                  
                  170,000
                  
                  6.04
                  %Jin
      S. Kim
                    34
      Piney Meetinghouse Ct, Potomac, MD 20854
                  
                  
                  516,700
                  
                  18.35
                  %All
      5% Stockholders as a group (6 persons)
                  
                  
                  1,352,200
                  
                  48.01
                  %Total:
      Directors, Executive Officers, and 5% Stockholders
                  
                  
                  1,907,500
                  
                  67.73
                  %







(1)
            Includes
      exercisable options to purchase 200,000 shares of common
      stock.




(2)
            Includes
      37,500 shares of common stock held by
spouse.




(3)
            Includes
      exercisable options to purchase 200,000 shares of common
      stock.





The
information regarding the Company’s equity compensation plans required by this
item is incorporated herein by reference to Item 5 of Part II of this annual
report.





ITEM
13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
INDEPENDENCE




Related
Party Transactions





From time
to time, in the ordinary course of our business, we enter into loan transactions
(both as lender and borrower) with our directors and executive officers, persons
who beneficially own more than 5% of our outstanding common stock, and the
family members and other affiliates of such persons.  All such
transactions are consummated on substantially the same terms, including interest
rates and collateral, as those prevailing for comparable transactions with other
customers.




56





During
2007, we obtained approximately $24.6 million in short-term funds from 28
persons, some of whom were directors and executive officers.  Of these
transactions, the only loans that exceeded the disclosure threshold in Item 404
of Regulation S-K were three loans from our Secretary, Louise Sehman, in the
aggregate amount of $296,424, which are payable on demand and bear interest at
an annual rate of 7.6%.





In 2007
and 2008, we purchased, in the aggregate, loans totaling $0.89 million and $ 0,
respectively, from Eweb Funding Group, LLC and American Industry Group, LLC,
which are controlled by Solomon Kaspi (a person holding more than 5% of our
outstanding common stock).  These loans were purchased at prices
between 100% and 103.5% of par, depending on the creditworthiness of the
borrowers, the collateral securing the loans, the interest rate payable on the
loans, and other credit-related variables.  All of these transactions
were consummated on substantially the same terms, including interest rates and
collateral, as those prevailing for comparable transactions with unrelated
lenders.





The
following table sets forth information with respect to investments in our
investor notes since January 1, 2007 by our directors, executive officers,
immediate family members of our directors and executive officers, and companies
affiliated with our directors and executive officers, in which the amount
involved exceeded the lesser of $120,000 or 1.00% of our average total assets at
year-end for the last two completed fiscal years.





INVESTOR
      NOTE ACCOUNTSInvestor
            
            Relationship
            
            Beginning
      Balance
            
            
            Balance
      as of 12/31/08
            
            
            Highest
      Balance
              During
      Period
              1/1/2007
      –
              12/31/2008
            
            
            Interest
      RateLouise
      Sehman
            
            Officer
            
            $
            77,135
            
            
            $
            130,720
            
            
            $
            255,123
            
            
            
            7.50
            %Richard
      Allen
            
            Stockholder
            
            $
            1,882
            
            
            $
            (9,498
            )
            
            $
            152,319
            
            
            
            4.75
            %Robert
      Harris
            
            CEO
            
            $
            7,635
            
            
            $
            (5,444
            )
            
            $
            302,699
            
            
            
            4.75
            %





In
January 2008, we repurchased 150,000 shares of our common stock from our
President/CEO, Robert L. Harris, for an aggregate purchase price of
$300,000.





Director
Independence





The Board of Directors has determined
that each of Jack H. Bresko and Alvin Shapiro is an “independent director” as
that term is defined by Section 803A(2) of the American Stock Exchange Company
Guide.  During the period in 2008 that he served as a director, Mr.
Feldman was an “independent director”.  Mr. Shapiro satisfies the
audit committee independence requirements of Section 803B(2) of the American
Stock Exchange Company Guide.  Mr. Connor does not satisfy these audit
committee independence requirements because the Company paid him a small amount
of consulting fees in 2008.





ITEM
14. PRINCIPAL ACCOUNTANT FEES AND SERVICES




As our independent registered public
accounting firm for 2007 and 2008, Stegman & Company provided various audit
and other services for which we were billed for fees as further described below.
Except as described below, the Audit Committee specifically pre-approves all
audit services and other services provided by Stegman &
Company.  In the case of tax services and other permissible non-audit
services, the Audit Committee has delegated authority to its Chairman to approve
services.  Any approval of additional services by the Chairman is
communicated to the full Audit Committee at its next regularly scheduled
meeting.  The Audit Committee also may authorize management to obtain
tax services from Stegman & Company from time to time during the year up to
a specified aggregate amount of fees.  Any tax services obtained by
management are communicated to the Audit Committee at its next regularly
scheduled meeting.




57




The following table shows the fees paid
or accrued by us for the audit and other services provided by Stegman &
Company during fiscal years 2008 and 2007:





2008
              
              
              2007Audit
      Fees
              
              $
              77,500
              
              
              $
              47,094Audit-Related
      Fees
              
              
              9,000
              
              
              
              -Tax
      Fees
              
              
              7,250
              
              
              
              7,250All
      Other Fees
              
              
              -
              
              
              
              -Total
              
              $
              93,750
              
              
              $
              54,344





Audit Fees paid or incurred in fiscal
years 2008 and 2007 include charges for auditing our annual financial statements
and for quarterly reviews of financial statements.  Audit-Related Fees
paid or incurred in 2008 include charges for reviewing amendments of our
investor note registration statement.  Tax Fees paid in fiscal years
2008 and 2007 include charges primarily related to tax return
preparation.





The Audit Committee has reviewed
summaries of the services provided and the related fees and has determined that
the provision of non-audit services is compatible with maintaining the
independence of Stegman & Company.  All of the 2008 and 2007
services described above were pre-approved by the Audit Committee.





PART
IV





ITEM
15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES





(a)(1),
(2) and (c) Financial Statements.





Report of
Independent Registered Public Accounting Firm




Balance
Sheets as of December 31, 2008 and 2007




Statements
of Operations for the years ended December 31, 2008 and 2007 and
2006




Statements
of Changes in Stockholders’ (Deficit) Equity for the years ended December 31,
2008 and 2007




Statements
of Cash Flows for the years ended December 31, 2008 and 2007




Notes to
Financial Statements for the years ended December 31, 2008 and 2007





(a)(3)
and (b)  Exhibits.





The exhibits filed or furnished with
this annual report are shown on the Exhibit Index that follows the signatures to
this annual report, which Exhibit Index is incorporated herein by
reference.




58





SIGNATURES




Pursuant to the requirements of Section
13 or 15(d) 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
      COMPANYDated:  April
      15, 2009
              By:
              /s/
      Robert L. HarrisRobert
      L. HarrisPresident/CEO
      and Acting Chief Financial Officer




Pursuant to the requirements of the
Securities Exchange Act of 1934, this report has been signed below by the
following persons on behalf of the registrant and in the capacities on April 15,
2009.




/s/
      Robert L. Harris
            
            
            /s/
      Jack H. BreskowRobert
      L. Harris, President/CEO, Acting
            
            
            Jack
      H. Breskow, DirectorChief
      Financial Officer, and Director




/s/
      Jeremiah A. Connor
              
              
              /s/
      Alvin ShapiroJeremiah
      A. Connor, Director
              
              
              Alvin
      Shapiro, Director





59




EXHIBIT INDEX





Exhibit
            
            Description3.1(i)
            
            Articles
      of Incorporation of KH Funding Company (Incorporated by reference to
      Exhibit 3.1 of the Registrant’s Registration Statement on Form SB-2 filed
      on June 26, 2003, File No. 333-106501)3.1(ii)
            
            Articles
      of Amendment of KH Funding Company (Incorporated by reference to Exhibit
      3.2 of the Registrant’s Registration Statement on Form SB-2 filed on June
      26, 2003, File No. 333-106501)3.2
            
            Bylaws
      of KH Funding Company (Incorporated by reference to Exhibit 3.3 of the
      Registrant’s Registration Statement on Form SB-2 filed on June 26, 2003,
      File No. 333-106501)4.1
            
            Indenture
      by and between KH Funding Company, as Issuer, and Wells Fargo Bank
      Minnesota, N.A., as Trustee, dated August 27, 2003 (Incorporated by
      reference to Exhibit 4 of the Registrant’s Registration Statement on Form
      SB-2 filed on June 26, 2003, File No. 333-106501)4.2
            
            Indenture
      by and between KH Funding Company, as Issuer, and Wells Fargo Bank
      Minnesota, N.A., as Trustee, dated August 2, 2004 (Incorporated by
      reference to Exhibit 4 of the Registrant’s Post-Effective Amendment No. 1
      to the Registration Statement on Form SB-2 filed on July 11, 2005, File
      No. 333-117038)4.3
            
            First
      Supplemental Indenture by and between KH Funding Company, as Issuer, and
      Wells Fargo Bank, N.A., as Trustee, dated July 1, 2005 (Incorporated by
      reference to Exhibit 4.3 of the Registrant’s Pre-Effective Amendment No. 2
      to the Registration Statement on Form SB-2 filed on July 1, 2005, File No.
      333-124155)4.4
            
            Security
      Agreement by and between KH Funding Company, as Issuer, and Wells Fargo
      Bank, N.A., as Trustee, dated May 18, 2005 (Incorporated by reference to
      Exhibit 4.4 of the Registrant’s Pre-Effective Amendment No. 1 to the
      Registration Statement on Form SB-2 filed on June 1, 2005, File No.
      333-124155)4.5
            
            Deposit
      Account Control Agreement by and among KH Funding Company, as Issuer,
      Wells Fargo Bank, N.A., as Trustee, and Access National Bank, dated June
      15, 2005 (Incorporated by reference to Exhibit 4.5 of the Registrant’s
      Pre-Effective Amendment No. 2 to the Registration Statement on Form SB-2
      filed on July 1, 2005, File No. 333-124155)4.6
            
            Amended
      and Restated Second Supplemental Indenture by and between KH Funding
      Company, as Issuer, and Wells Fargo Bank, N.A., as Trustee, dated January
      16, 2008 (Incorporated by reference to Exhibit 4.6 of the Registrant’s
      Post-Effective Amendment No. 2 to the Registration Statement on Form SB-2
      filed on January 23, 2008 (File No. 333-135330)4.7
            
            Account
      Control Agreement by and among KH Funding Company, as Issuer, Wells Fargo
      Bank, N.A., as Trustee, and the brokerage company a party thereto, dated
      September 17, 2007 (Incorporated by reference to Exhibit 4.7 of the
      Registrant’s Post-Effective Amendment No. 2 to the Registration Statement
      on Form SB-2 filed on January 23, 2008 (File No.
    333-135330)4.8
            
            Deposit
      Account Control Agreement by and among KH Funding Company, as Issuer,
      Wells Fargo Bank, N.A., as Trustee, and Bank of America, N.A., dated
      October 17, 2006 (Incorporated by reference to Exhibit 4.8 of the
      Registrant’s Post-Effective Amendment No. 1 to the Registration Statement
      on Form SB-2 filed on August 10, 2005, File No.
  333-135330)10.1
            
            1998
      Stock and Incentive Plan (Incorporated by reference to Exhibit 10.1 of the
      Registrant’s Registration Statement on Form SB-2 filed on June 26, 2003,
      File No. 333-106501)10.2
            
            Form
      of Participation Agreement (Incorporated by reference to Exhibit 10.2 of
      the Registrant’s Registration Statement on Form SB-2 filed on June 30,
      2005, File No. 333-117038)10.3
            
            2005
      Equity Incentive Plan (Incorporated by reference to Exhibit 10.3 of the
      Registrant’s Registration Statement on Form SB-2 filed on June 10, 2005,
      file No 333-124155)10.4
            
            Selling
      Agreement by and between KH Funding Company and Spencer Edwards, Inc.
      (Incorporated by reference to Exhibit 10.3 of the Registrant’s Form 10-KSB
      for the year ended December 31, 2004)10.5
            
            Selling
      Agreement by and between KH Funding Company and Capital Financial
      Services, Inc. (Incorporated by reference to Exhibit 10.3 of the
      Registrant’s Registration Statement on Form SB-2 filed on June 30, 2005,
      file No. 333-117038)10.6
            
            Selling
      Agreement by and between KH Funding Company and CapWest Securities, Inc.
      (Incorporated by reference to Exhibit 10.6 of the Registrant’s
      Pre-Effective Amendment No. 1 to the Registration Statement on Form SB-2
      filed on August 10, 2005, File No. 333-135330)10.7
            
            Promissory
      note dated July 12, 2006 issued by Jin Suk Kim to KH Funding Company and
      related Pledge Agreement and Guaranty (Incorporated by reference to
      Exhibit 10.1 of the Registrant’s Form 10-QSB for the quarter ended June
      30, 2007)10.8
            
            Promissory
      note dated August 10, 2006 issued by Jin Suk Kim to KH Funding Company and
      related Indemnity Deed of Trust and Security Agreement (Incorporated by
      reference to Exhibit 10.2 of the Registrant’s Form 10-QSB for the quarter
      ended June 30, 2007)10.9
            
            Promissory
      note dated September 12, 2006 issued by Jin Suk Kim to KH Funding Company
      (Incorporated by reference to Exhibit 10.3 of the Registrant’s Form 10-QSB
      for the quarter ended June 30,
2007)




60




31.1
            
            Certifications
      by the Chief Executive Officer and Chief Financial Officer pursuant to
      Section 302 of the Sarbanes-Oxley Act of 2002 (filed
    herewith)32.1
            
            Certification
      by the Chief Executive Officer and Chief Financial Officer Pursuant to 18
      U.S.C. Section 1350 Adopted Pursuant to Section 906 of the Sarbanes-Oxley
      Act of 2002 (furnished herewith)




61