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

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

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

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

NOTE C— LOANS RECEIVABLE, IMPAIRED LOANS AND ALLOWANCE FOR LOAN LOSSES

 

Loans Receivable

Loans receivable are stated as unpaid principal balance net of any deferred fees and payments in process, less the allowance for loan losses.

Interest income from loans receivable is recognized using the interest method whereby interest income is recognized using the loan’s effective rate based upon outstanding principal. Loan origination fees received from borrowers are deferred and amortized into income over the established average life of related loans under a method which approximates the effective interest rate method. Loan premiums and discounts are also amortized into interest income under the same method.

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

 

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The Company incurs direct loan origination costs in its direct lending activities. These costs are capitalized and amortized against interest income over the estimated average life of the loans under a method which approximates the effective interest rate method.

Impaired Loans

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

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

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

		For the nine months ended September 30, 2009				For the year ended December 31, 2008
		(unaudited)
Average recorded investment in impaired loans during period		$	4,129,704			$	2,949,641
Related amount of interest income recognized within period when loans were impaired		$	–			$	–
Amount of income recognized using cash basis during time within period that loan was impaired		$	–			$	–

At September 30, 2009 and December 31, 2008, the Company had loans of $6,570,907 and $10,006,949, respectively, which were more than 90 days past due and for which the Company continues to accrue interest.  The Company believes that these loans are adequately secured and that both the principal and the related accrued interest are collectible.

Analysis of the allowance for loan losses is as follows:

		For the nine months ended September 30, 2009				For the nine months ended September  30, 2008
		(unaudited)				(unaudited)
Beginning balance		$	659,297			$	495,480
Provision for loan losses			624,607				272,384
Loans charged off			(417,756	)			(107,440	)
Ending Balance		$	866,148			$	660,424

 

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

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

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

NOTE D—RELATED PARTY TRANSACTIONS

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

Included in the notes receivable mentioned above at September 30, 2009 and December 31, 2008 are six loans in the amount of $10.48 million and $010.19 million, respectively, to a trust for the benefit of a significant stockholder.  The proceeds of these loans were used to purchase real estate which serves as security for the loans.  The Company holds a first or second lien position with respect to the collateral securing approximately $9.75 million of these loans as well as other real and personal collateral for September 30, 2009 and December 31, 2008, respectively.  The loans bear interest at 8% per annum and have some variable up-side features. Additional interest is earned on certain loans if the rental income the borrower receives from the property exceeds certain allowable expenses. In addition, upon the sale of certain real property(ies) (or components thereof), the Company is to receive one quarter or one-half, depending on the specific property, of any gain after adjusting for certain costs and commissions. The loans do not have any variable down-side features which would cause interest to be lower than the stated rate on each loan. Under the terms of the loans any refinancing or sale of the properties must be approved by the Company in advance.

Included in the notes payable and other loans payable balances at September  30, 2009 and December 31, 2008, are 49 notes totaling $5,976,873 and 56 notes totaling $7,163,483, respectively, which are held by officers and stockholders.  These notes were issued at the rates in effect for the applicable terms selected as of the date the notes were issued.

There is an interest-only demand note receivable of $185,450 included in other receivables, shown on the balance sheet at September 30, 2009 and December 31, 2008 as contra-equity, made to the Company’s CEO for the purchase of 100,000 shares of stock in the Company, which secures the loan.  The interest rate on this loan is 7%.  At September 30, 2009 and December 31, 2008, all payments under this loan had been timely made and there was no accrued interest receivable on this loan.

 

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

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

NOTE E—STOCK BASED COMPENSATION

The Company has granted stock-based compensation awards to employees and directors.  Awards may consist of common stock or stock options.  The Company’s stock options have five-year terms and vest over three years in three equal annual installments. The stock options provide for option exercise prices equal to or greater than the fair market value of the common stock at the date of the grant, as determined by the Board on the grant date.

No stock options were granted during the nine months ended September 30, 2009 or 2008.  During the nine months ended September 30, 2009, 161,250 options expired.

The Company accrues related compensation expenses as its options vest in accordance with FASB guidance regarding Share-Based Payment.  The Company recognized $11,767 and $10,573 stock-based compensation expense during the nine months ended September  30, 2009 and 2008, respectively, from the vesting of stock options issued in earlier periods.  Stock-based compensation includes the value of stock granted to directors for their service, which was $0 and $0, respectively, for the nine months ended September 30, 2009 and 2008.

A summary of stock option activity during the nine months ended September 30, 2009 and related information is included in the table below:

		Number of Options				Weighted- Average Exercise Price				Weighted-Average Remaining Contractual Life (in years)				Aggregate  Intrinsic Value
Outstanding at January 1, 2009			241,250			$	2.39							$	-
Granted			–
Exercised			–
Forfeited or expired			161,250				2.00								-
Outstanding at September  30, 2009			80,000				3.19				1.78				-
Exercisable at September 30, 2009			80,000				3.19				1.78				-

Warrants

In January 2009, the Company issued warrants to purchase 250,000 shares of common stock with an exercise price of $1.00 per share.  These warrants were issued in connection with the private placement of 500,000 shares of common stock at $1.00 per share in January 2009.  In this private placement, one warrant was issued for each two shares of common stock sold.  The warrants expire in January 2014.  These warrants represent the only warrants outstanding at September 30, 2009 and their issuance in the only warrant activity for the nine months then ended.  There were no warrants outstanding at September 30, 2008, nor was there any warrant activity for the nine months then ended.

 

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NOTE F—COMMITMENTS AND CONTINGENT LIABILITIES

Off-Balance Sheet Arrangements

 

         The Company enters into off-balance sheet arrangements in the normal course of its business. These arrangements consist primarily of lines-of-credit and draw-type loans. At September 30, 2009, the Company had $4.88 million in loans of this type.  The unused or unfunded amount on these types of loans totaled $0.79 million as of September 30, 2009.

NOTE G — COLLATERALIZED NOTES PAYBLE  

The Company borrows funds through the issuance of notes payable which are collateralized by other real estate owned.  The following table lists the collateralized notes which are outstanding at September 30, 2009:

 

		Interest rate			Due Date		Amount Owed			Payment Terms
			10.00	%	12/31/2009		$	207,000		Interest only payments due 1st of each month.
			10.00	%	12/31/2009			207,000		Interest only payments due 1st of each month.
			10.00	%	12/31/2009			205,086		Interest only payments due 1st of each month.
			8.00	%	12/5/2009			100,000		Interest only payments due 1st of each month.
			10.00	%	12/31/2009			200,000		Interest only payments due monthly.
			10.00	%	12/31/2009			125,000		Interest only payments due monthly.
			7.5	%	3/1/2010			470,000		Monthly payment of $6,000 principal plus interest earned
			7.5	%	8/31/2010			200,000		Interest accrued with principal curtailments as requested
			7.5	%	1/31/2010			584,360		Interest accrued with principal curtailments as requested
Total Collateralized Notes Payable							$	2,298,446

NOTE H— LOAN PARTICIPATIONS SOLD WITH RECOURSE

From time to time, the Company sells participation interest in its loans.  The participation interests are typically sold with recourse to the Company (the Company’s repurchase obligations are due on demand if the loan defaults) and the agreements typically provide for limited liability on the part of the holder of the participation interest.  During the nine-month period ended September 30, 2008, the Company entered into three such participation agreements and received a total of $3.18 million and paid down one existing agreement in the amount of $27,736.  During the same period of 2009, the Company paid down existing agreements in the amount $927,164 and did not enter into any additional agreements.  The details of the Company’s existing participation agreements are as follows:

		Interest Rate			Date Due		Amount owed			Payment Terms
			12.50	%	10/24/2008		$	203,764		Interest only payment monthly
			10.00	%	6/1/2010			451,000		Interest only payment monthly
			9.04	%	at maturity			2,483,527		Interest and principal payment monthly
			10.00	%	at maturity			389,243		Interest and principal payment monthly
Total Loans Sold with Recourse							$	3,527,534

 

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

NOTE  I—FAIR VALUE MEASUREMENTS

 

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

 

Level 1

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

Level 2

Inputs to the valuation methodology include:

·

quoted prices for similar assets or liabilities in active markets;

·

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

·

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

·

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

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

Level 3

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

 

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

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

Impaired Loans

 

The Company does not record loans at fair value on a recurring basis; however, from time to time, a loan is considered impaired and an allowance for loan loss is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan are considered impaired. Once a loan is identified as individually impaired, management measures impairment in accordance with FASB guidance regarding “Accounting by Creditors for Impairment of a Loan”. The fair value of impaired loans is estimated using one of several methods, including the collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Those impaired loans not requiring a specific allowance represents loans for which the fair value of expected repayments or collateral exceed the recorded investment in such loans. At September 30, 2009, substantially all of the totally impaired loans were evaluated based upon the fair value of the collateral. In accordance with FASB guidance, impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the loan as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the loan as nonrecurring Level 3.

 

Assets and Liabilities Recorded as Fair Value on a Nonrecurring Basis

 

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

 

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

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

 

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

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

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

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

Recent Government Actions

In recent months, the United States Congress, the United States Department of the Treasury and various federal regulators have taken steps to control the financial crises affecting the banking system and financial markets and going concern threats to investment banks and other financial institutions.  These steps have included the enactment of the Emergency Economic Stabilization Act of 2008, the American Recovery and Reinvestment Act of 2009, the Treasury’s Troubled Asset Relief Program Capital Purchase Plan and Capital Assistance Program, and the Federal Deposit Insurance Corporation’s Temporary Liquidity Guarantee Program.  These laws and programs were intended to stabilize the financial industry, restore confidence in the industry, and ease liquidity concerns so that, among other things, financial institutions will increase their lending efforts, both with respect to consumers and other businesses.  Because our primary business activity is making and purchasing loans, we believe that the success of these initiatives will have an impact on us, although there can be no assurance as to if, when or the extent to which we will see market improvements or any impact on our business and operations.

 

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Overview

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

Prior to 2007, our business activities consisted of purchasing mortgage loans (80% of our business) and of originating, acquiring and servicing mortgage loans (20% of our business).  Since 2007, our business activities have been limited to funding existing lines of credit and draw-down loans and otherwise servicing our existing loan portfolio.  To fund our operations and to satisfy our obligations under our outstanding investor notes, including redemption requests, we have traditionally relied on (i) funds received from loan pay-offs, (ii) interest and other fee income received on our loans, and (iii) funds raised through the issuance of interest-bearing debt securities to investors.  However, we were unable to sell any of our investor notes between May 2006 and November 2008 and had only a limited window of selling between November 2008, when our most recent registration statement became effective, and April 30, 2009, when it expired.  While we were unable to sell our investor notes, our operations were funded solely through loan pay-offs, interest and other income received on our loans, and unsecured short-term borrowings.

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

In prior periods, we used funds obtained from loan repayments and offerings of our investor notes to originate most of the loans in our portfolio.  However, rather than directly originating new loans, in the last six years we have increasingly engaged in the wholesale purchase of loans for our loan portfolio and are now purchasing approximately 80% of our new loans.  We intend to continue to expand this wholesale component of our operations and expect it to continue to be a major part of our loan acquisition strategy.  This strategy is aimed at enabling us to expand our operations with a limited amount of additional personnel and expense because we anticipate that only a minimal expansion of our administrative functions will be needed to support an increased wholesale component in our operations.  We plan to identify and utilize additional brokers, lenders and banks as sources for our loan acquisitions.

 

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

Starting in the fourth quarter of 2004, we expanded the distribution for our investor notes by engaging in strategic alliances with several major financial services firms throughout the country.  Although we are not currently able to publicly sell our investor notes, we do have a signed selling agreement with a FINRA registered broker-dealer with a network of over 400 registered representatives in the Midwest and West.  In the past, these alliances have given us the ability to sell our investor notes through a network of financial intermediaries in defined geographic locations.  Through the middle of 2006, our distribution plan was very successful, establishing close to 700 new investment accounts providing us with over $25,000,000 in funds.  In the first four months of 2006, sales by these broker-dealers established another approximately 522 new investment accounts and provided over $11 million in funds.  If and when we are able to recommence our public offering efforts, we plan to further increase our distribution network including in parts of the United States where we are not currently represented.

Critical Accounting Policies

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

 

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

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

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

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

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

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

Past Due Loans.  As of  September 30, 2009, we held 34 loans that were more than 90 days past due but still accruing interest, compared to twenty-one as of December 31, 2008.  The total principal and interest due on these loans was $6.57 million compared to $10.01 million as of December 31, 2008.  Twenty-three of the loans, totaling $5.77 million, are first mortgage loans on which we do not expect to suffer any loss due to the underlying collateral values.  The borrowers under the remaining eleven loans, totaling $0.80 million, are making scheduled payments, and we continue to accrue interest on these loans based on the underlying collateral values and payment histories.  We monitor these loans on a continuous basis.

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

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

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

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

 

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

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

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

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

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

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

 

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

 

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

 

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

 

Interest Income.  Total interest income was $754,710 for the three months ended September 30, 2009, compared to $989,629 for the same period in 2008.  The decrease in interest income resulted from a decrease in total loan portfolio due to loan payoffs and   lack of loan originations.  The interest income includes point and fee income and interest earned on bank investments and marketable securities.

 

Interest Expense.  Interest expense was $740,446 for the three months ended September 30, 2009 and $835,993 for the corresponding period in 2008.  The decrease in interest expense was due to a reduction in total investor notes payable due to redemptions.  The interest expense includes the amortization of fees paid to Brokers-Dealers in prior periods for the sale of investor notes.

 

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

 

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

 

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

 

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

Liquidity and Capital Resources

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

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

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

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

We require cash and cash equivalents to fund and purchase loans and to satisfy redemption requests from holders of our outstanding investor notes.  Historically, our primary sources of funding have been the proceeds from the sale of investor notes, principal and interest payments received on loans receivable and investments, proceeds from the sale of loans and rental income from real estate owned and held for rental.  As discussed elsewhere in this report, we have enjoyed only a limited period of time during the past three years (from November 2008 to April 2009) during which we were able to raise cash for operations through the sale of our investor notes, and this inability to raise significant funds has substantially hampered our business operations and put stresses on the Company, including on its ability to timely meet its redemption and other payment obligations under its investor notes.  Although we are working to file the necessary information with our securities regulators to have our offering reinstated, there can be no guaranty as to when this might occur.  Moreover, although maturities and scheduled amortization of loans receivable and investments are predictable sources of funds, the sale and redemption of investor notes and mortgage loan prepayments are greatly influenced by interest rate trends, economic conditions and competition.

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

 

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

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

Redemption requests from holders of our one-day and thirty day demand investor notes can cause significant volatility in our cash balances.  Holders of our one-day demand investor notes can request a redemption immediately after investment, and we are required to redeem the note within one day after receiving the request.  Holders of our thirty-day demand investor notes can likewise request a redemption immediately after investment, but we are required to redeem the note within 30 days after receiving the request.  All other types of investor notes are redeemable upon maturity, or prior to maturity on 90 days advance notice, subject to a penalty.  These features, along with our maximum investment guidelines, were designed to provide us with ample time to satisfy redemption requests.  Under the Indenture related to our outstanding investor notes, we will be in default if we fail to satisfy a redemption request within 30 days of the date set for redemption, unless we obtain a waiver from each of the note holders who have requested redemption.  Upon a default, for so long as such default is continuing, the Indenture Trustee and/or the holders of at least 25% of the principal amount of our outstanding investor notes are permitted, but not required, to accelerate the maturity of all outstanding notes and take other actions permitted by the Indenture.  Such an acceleration would likely require us to liquidate the Company.

When we sell an investor note, management determines how it wants to use the proceeds.  Generally, our business strategy is to retain some of the proceeds as cash and cash equivalents and to use the remaining proceeds to fund loans and/or purchase other assets, such as mortgages and investment securities that have higher yields than the yields that we pay on our investment notes.  Unlike cash, however, investments in mortgages and securities may not always provide us with immediate liquidity.  For example, we generally buy and originate more loans than are immediately saleable, but we try to structure our loan acquisitions so that they may be sold within our 30-day grace period for satisfying redemption requests.  However, it must be noted that any sale of loans must comply with the requirements of the Trust Indenture Act of 1939 and may require the consent of the trustee for investor notes.

At September 30, 2009, we held approximately $26.75 million in residential and commercial mortgage loans that we believe could be sold within a short period of time for the purpose of satisfying investor note redemption requests.  Although, in the current market, the price would probably be below par and instead, we are trying to sell non-interest earning assets to satisfy pending investor redemption requests.  These sales are discussed in more detail under “Recent Developments” in the second paragraph of Item 2. Section I. Further, we held $1.30 million in second mortgage loans at September  30, 2009, which earn higher yields than the first mortgage loans and that we believe could also be sold, although generally they take longer to sell and are sold at a discount.  It should be noted, however, that the national and local real estate economies have weakened during the past two years in part due to the widely-reported problems in the sub-prime mortgage loan market.  These problems have had the effect of decreasing the amount of credit that is available to borrowers.  As a result, sellers of real estate and loans secured by real estate have found it more difficult in recent years to sell their assets at the times and at the prices they desire.

Because of the legal and market factors discussed above, we may not always be able to sell loans or other assets to meet redemption requests within the 30-day grace period.  As of September 30, 2009, we were subject to redemption requests with respect to approximately $0.23 million of outstanding investor notes that are within the 30-day grace period for repayment and redemption requests of $3.67 million of outstanding series 3 and series 4 investor notes that are beyond the 30-day grace period for repayment.  For those notes that are beyond the grace period, we have either obtained waivers from each of the note holders or are working to obtain waivers.  Included in the above amounts of outstanding note redemptions, we are more than 30 days late in satisfying our payment obligations with respect to approximately $1.76 million of our series 3 and series 4 investor notes that have matured.  Accordingly, we are in default under the Indenture. To date, neither the Indenture Trustee, to whom we make regular reports regarding redemption status and late payments, nor the holders of at least 25% of the aggregate amount of outstanding investor notes have notified us that they intend to accelerate all outstanding notes because of this event of default, but, as noted above, they have the ability to do so for so long as our default continues.

 

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

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

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

Known Trends, Events of Uncertainties

Impact of Inflation and Interest Rates. The financial statements of the Company and notes thereto, presented elsewhere herein, have been prepared in accordance with accounting principles generally accepted in the United States of America, which require the measurement of financial position and operating results in terms of historical dollars without considering the change in the relative purchasing power of money over time and due to inflation. The impact of inflation is generally to increase the value of underlying collateral for the loans made by the Company to its borrowers. Unlike typical industrial companies, nearly all the assets and liabilities of the Company are monetary in nature. As a result, interest rates have a greater impact on our performance than the effects of inflation generally.

Stockholders’ Deficit. Total stockholders’ equity has decreased as a percentage of total assets over the last nine years, from 10.6% at December 31, 1999 to a deficit of (3.47%) at September 30, 2009. During the period ending September 30, 2009, we experienced an operating loss of $1,598,281 combined with stock sales of $500,000 resulting in an ending stockholders deficit of $1,468,644. Our Board suspended the payment of stock dividends after the second quarter of 2007 to help maintain sufficient equity levels.

Sub-Prime Loans and Lending. Recently, the sub-prime mortgage lending environment has experienced considerable strain from rising delinquencies and liquidity pressures. Several high profile sub-prime mortgage lenders have failed, and these failures have adversely impacted the financial markets and economy in general. These market conditions have resulted in increased scrutiny of sub-prime lending practices. Although we make and acquire loans that may be considered “sub-prime loans”, we believe that our exposure to problems in the industry is limited as a result of several factors. First, at September 30, 2009 our sub-prime loans amounted to only $2.37 million, or 7.84% of our total loans. Second, we believe that we underwrite our sub-prime loans to a higher standard than that employed by some of the more aggressive lenders. Third, we do not offer or purchase the types of sub-prime loans that are receiving the harshest criticism from regulators, commentators and Congress. Notably, as a general matter, the sub-prime loans that we originate and purchase have loan to value (“LTV”) ratios that are less than 70%, as opposed to ratios of 95% or higher allowed by many sub-prime lenders. In addition, we do not offer so-called “teaser” rate adjustable loans, low or no document or “stated income” loans. Fourth, we do not generate or purchase high volumes of sub-prime loans, so we are able to look much more closely at the ability of individual borrowers to repay their loans. In the case of purchased loans, we rely on strict purchase criteria relating to LTV ratios and documentation. Notwithstanding the foregoing, we are subject to some exposure to losses because we do carry some sub-prime loans. For example, if real estate values in our markets continue to decline and our sub-prime borrowers were to default, the collateral securing these loans might not be sufficient to fully repay the loan balances. This risk applies equally to all of our loans.

 

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Item 4.  Controls and Procedures.

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934 with the SEC, such as this Quarterly Report, is recorded, processed, summarized and reported within the time periods specified in those rules and forms, and that such information is accumulated and communicated to Management, including the Chief Executive Officer, who also serves as the acting Chief Financial Officer (“CFO”), to allow for timely decisions regarding required disclosure.  A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met.  Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs.  These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake.  Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control.  The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, control may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate.

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

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

PART II – OTHER INFORMATION

Item 1.  Legal Proceedings

On November 6, 2008, we received a copy of a complaint that was filed by Samar Ghadry in Montgomery County, Maryland Circuit Court against us, Prime Global Securities, Inc., Forum Trading Corp., FTC Capital Markets, Inc., FTC Group, Inc., Pension Financial Services, Inc., Martin Angeli, and Sonia Aguirre Pietri De Angeli.  This litigation relates to the actions of Martin Angeli, our former Senior Vice President. In her complaint, Ms. Ghadry alleges that she and Mr. Angeli entered into a stock selling agreement whereby Mr. Angeli agreed to sell securities for her at $2.00 per share, but actually sold them at $2.50 per share and retained the excess, which amounted to $864,298.20.  Although Ms. Ghadry alleges that we were also a party to this stock selling agreement, we have no knowledge of any such agreement nor was any officer of KH Funding authorized to execute such an agreement on our behalf.  Ms. Ghadry further alleges that Mr. Angeli caused these excess funds to be wired to an investor account at KH Funding held by his mother, Sonia Aguirre Pietri De Angeli, and then to an account at another institution also held by his mother, thereby depriving Ms. Ghadry of these funds.  Ms. Ghadry alleges that Mr. Angeli forged her signature on the initial wire authorization and that one of our employees notarized that signature, and that our actions, or failures to act, with respect to these wire transactions and our supervision of Mr. Angeli make us liable to her.  The wire transaction report we received did not indicate the account for which the funds were earmarked, but because Mr. Angeli had apprised us that his mother intended to make this investment we relied on him for confirmation of the wire and deposited the funds into his mother’s account.  Although we subsequently confirmed that the wire instructions did in fact reference the account of Mr. Angeli’s mother, we have also learned that the instructions seem to indicate that the funds were intended for further credit to Ms. Ghadry.  We have been unable to confirm any of these allegations or that any wrongdoing actually took place.  In fact, the information we have obtained to date lead us to believe that no wrongdoing took place and that Ms. Ghadry authorized any and all actions taken by Mr. Angeli on her behalf or for her account, which, if they occurred, were conducted outside the scope of his employment with us.  Ms. Ghadry’s claims against us include breach of contract, fraud, breach of fiduciary duty, conversion, negligent supervision, negligence, re-credit of account for unauthorized transfers, aiding and abetting conversion, aiding and abetting fraud, and aiding and abetting breach of fiduciary duty.  Ms. Ghadry seeks compensatory damages from us in the amount of $864,298.20 and punitive damages from us in the amount of $5.0 million, plus costs and interest.  We believe that we have strong defenses to these claims and intend to vigorously defend this lawsuit, although we cannot predict the outcome of this litigation or its financial impact on us.  We have insurance policies in place that we believe would provide coverage for up to $3.0 million, but there can be no assurance that our policies will cover any or all of these claims.

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

 

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Item 1A.  Risk Factors

The risks and uncertainties to which our financial condition and operations are subject are discussed in detail in Item 1A of Part I of our Annual Report on Form 10-K for the year ended December 31, 2008 and in Item 1A of Part II of our Quarterly Report on Form 10-Q for the quarter ended June 30, 2009.

Item 3.  Defaults Upon Senior Securities

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

Item 6.  Exhibits

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

SIGNATURES

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

	KH FUNDING COMPANY
Date:  November 16, 2009	By:	/s/ Robert L. Harris
		Robert L. Harris
		President, Chief Executive Officer,
		and Acting Chief Financial Officer

 

 

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EXHIBIT INDEX

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

 

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