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EX-32 - Sound Financial, Inc.ex-32.htm
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)
March 31,2011
[X]
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2011

OR

[  ]           TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE EXCHANGE ACT

For the transition period from _______ to ________

Commission file number:     000-52889


SOUND FINANCIAL, INC.
(Exact name of registrant as specified in its charter)

United States
26-0776123
(State or other jurisdiction of incorporation of organization)
(IRS Employer Identification No.)

2005 5th Avenue, Second Floor, Seattle, Washington 98121
(Address of principal executive offices)

(206) 448-0884
(Registrant’s telephone number)


None
(Former name, former address and former fiscal year, if changed since last report)


Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter 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 [X]  NO [   ]

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes [   ]   No [   ]

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See definition of “accelerated filer,” “large accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Act.

Large accelerated filer  o      
Accelerated filer  o      
Non-accelerated filer  o       
Smaller reporting company  x   
 
(Do not check if smaller reporting company)
 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  YES [   ]    NO [ X ]
 
Indicate the number of shares outstanding of each issuer's classes of common stock, as of the latest practicable date:
 

 
As of May 13, 2011, there were 2,954,295 shares of the registrant’s common stock outstanding.


 
 
 
 

SOUND FINANCIAL, INC.
FORM 10-Q
TABLE OF CONTENTS

 
Page Number
PART IFINANCIAL INFORMATION
 
 
Item 1.   Financial Statements
 
 
Condensed Consolidated Balance Sheets as of March 31,2011 (unaudited) and December 31, 2010
 
 
3
Condensed Consolidated Statements of Income for the Three Month Period Ended March 31,2011 and 2010 (unaudited)`
 
 
4
Condensed Consolidated Statement of Stockholders’ Equity for the Three Month Period Ended March 31,2011 (unaudited)
 
5
Condensed Consolidated Statements of Cash Flows for the Three Month Period Ended March 31, 2011 and 2010 (unaudited)
 
6
 
Selected Notes to Condensed Consolidated Financial Statements
 
 
7
Item 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations
 
24
Item 3.  Quantitative and Qualitative Disclosures About Market Risk
 
34
Item 4.  Controls and Procedures
 
34
PART IIOTHER INFORMATION
 
 
Item 1.     Legal Proceedings
 
36
Item 1A   Risk Factors
 
36
Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds
 
36
Item 3.  Defaults Upon Senior Securities
 
36
Item 4.  (Removed and Reserved)
 
36
Item 5.  Other Information
 
36
Item 6.  Exhibits
 
37
SIGNATURES
 
 
EXHIBITS
 

 
 
 
 

PART I                      FINANCIAL INFORMATION

Item 1                      Financial Statements

SOUND FINANCIAL, INC AND SUBSIDIARY
 
Condensed Consolidated Balance Sheets
 
(Dollars in thousands)
 
(unaudited)
 
   
MARCH 31,
   
DECEMBER 31,
 
   
2011
   
2010
 
ASSETS
     
Cash and cash equivalents
  $ 5,734     $ 9,092  
Available-for-sale securities (AFS), at fair value
    3,642       4,541  
Federal Home Loan Bank stock, at cost
    2,444       2,444  
Loans held for sale
    79       902  
Loans
    297,335       299,246  
Less allowance for loan losses
    (4,416 )     (4,436 )
Total loans, net
    292,919       294,810  
                 
Accrued interest receivable
    1,246       1,280  
Premises and equipment, net
    3,209       3,295  
Bank-owned life insurance, net
    6,791       6,729  
Mortgage servicing rights, at fair value
    3,146       3,200  
Other real estate owned and repossessed assets
    3,113       2,625  
Other assets
    4,674       5,721  
Total assets
  $ 326,997     $ 334,639  
                 
LIABILITIES
               
Deposits
               
Interest-bearing
  $ 247,546     $ 251,424  
Noninterest-bearing demand
    26,187       27,070  
Total deposits
    273,733       278,494  
Borrowings
    21,988       24,849  
Accrued interest payable
    95       121  
Other liabilities
    3,098       4,020  
Advance payments from borrowers for taxes and insurance
    409       252  
Total liabilities
    299,323       307,736  
COMMITMENTS AND CONTINGENCIES (NOTE 4)
               
STOCKHOLDERS' EQUITY
               
Preferred stock, $0.01 par value, 1,000,000 shares authorized, none outstanding
    -       -  
Common stock, $0.01 par value, 24,000,000 shares authorized, 2,954,295 issued
     and outstanding as of March 31, 2011 and December 31, 2010
    30       30  
Additional paid-in capital
    11,841       11,808  
Unearned shares - Employee Stock Ownership Plan (“ESOP”)
    (809 )     (809 )
Retained earnings
    17,041       16,545  
Accumulated other comprehensive loss, net of tax
    (429 )     (671 )
Total stockholders’ equity
    27,674       26,903  
Total liabilities and stockholders’ equity
  $ 326,997     $ 334,639  

                                  See notes to condensed consolidated financial statements

 
3
 
 

SOUND FINANCIAL, INC. AND SUBSIDIARY
Condensed Consolidated Statements of Income
(Dollars in thousands, except per share amounts)
(Unaudited)
   
THREE MONTHS ENDED MARCH 31,
 
   
2011
   
2010
 
INTEREST INCOME
 
(in thousands)
 
Loans, including fees
  $ 4,586     $ 4,593  
Interest and dividends on securities, cash and cash equivalents
    62       177  
                 
Total interest income
    4,648       4,770  
INTEREST EXPENSE
               
Deposits
    648       1,020  
FHLB advances and other borrowings
    104       148  
                 
Total interest expense
    752       1,168  
                 
NET INTEREST INCOME
    3,896       3,602  
                 
PROVISION FOR LOAN LOSSES
    825       1,425  
                 
NET INTEREST INCOME AFTER PROVISION
               
FOR LOAN LOSSES
    3,071       2,177  
                 
NONINTEREST INCOME
               
Service charges and fee income
    522       529  
Earnings on cash surrender value of bank owned life insurance
    62       66  
Mortgage servicing income
    135       165  
Fair value adjustment on mortgage servicing rights
    (1 )     285  
(Loss) gain on sale of securities
    (34 )     75  
Other-than-temporary impairment losses on securities
    (39 )     -  
Gain on sale of loans
    34       64  
                 
Total noninterest income
    679       1,184  
                 
NONINTEREST EXPENSE
               
Salaries and benefits
    1,466       1,617  
Operations
    669       834  
Regulatory assessments
    225       231  
Occupancy
    294       381  
Data processing
    239       200  
Losses and expenses on other real estate owned and repossessed assets
    139       48  
                 
Total noninterest expense
    3,032       3,311  
                 
INCOME BEFORE PROVISION (BENEFIT) FOR  INCOME TAXES
    718       50  
                 
PROVISION (BENEFIT) FOR INCOME TAXES
    222       (7 )
                 
NET INCOME
  $ 496     $ 57  
BASIC EARNINGS PER SHARE
  $ 0.17     $ 0.02  
DILUTED EARNINGS PER SHARE
  $ 0.17     $ 0.02  

See notes to condensed consolidated financial statements

 
4
 
 

SOUND FINANCIAL, INC. AND SUBSIDIARY
Condensed Consolidated Statement of Stockholders’ Equity
For the Three Months Ended March 31, 2011
(Dollars in thousands)
 (unaudited)

    
Shares
   
Common Stock
   
Additional
Paid-in
Capital
   
Unearned
ESOP
Shares
   
Retained
Earnings
   
Accumulated Other Comprehensive Loss, net of tax
   
Total
Stockholders’ Equity
 
   
(in thousands)
 
BALANCE, December 31, 2010
    2,954     $ 30     $ 11,808     $ (809 )   $ 16,545     $ (671 )   $ 26,903  
                                                         
Other comprehensive income:
                                                       
                                                         
Net income
                                    496               496  
                                                         
Net unrealized gain in
fair value of available for
sale securities, net of
tax  of $118
                                            242       242  
                                                         
Total comprehensive income
                                                    738  
                                                         
Compensation related to stock
     options and restricted stock
                    33                               33  
                                                         
BALANCE, March 31, 2011
    2,954     $ 30     $ 11,841     $ (809 )   $ 17,041     $ (429 )   $ 27,674  
                                                         

See notes to condensed consolidated financial statements

 
5
 
 

SOUND FINANCIAL, INC. AND SUBSIDIARY
Condensed Consolidated Statements of Cash Flows
(Dollars in thousands)
 (unaudited)
 
 
   
Three Months Ended March 31,
 
   
2011
   
2010
 
CASH FLOWS FROM OPERATING ACTIVITIES
     
Net income
  $ 496     $ 57  
Adjustments to reconcile net income to net cash from operating activities
               
Accretion of net premium on investments
    -       (199 )
Loss (gain) on sale of available for sale securities
    34       (75 )
Other-than-temporary impairment on available for sale securities
    39       -  
Provision for loan losses
    825       1,425  
Depreciation and amortization
    99       166  
Compensation expense related to stock options and restricted stock
    33       33  
Fair value adjustment on mortgage servicing rights
    1       (285 )
Additions to mortgage servicing rights
    (148 )     (99 )
Amortization of mortgage servicing rights
    201       136  
Increase in cash surrender value of bank owned life insurance
    (62 )     (66 )
Proceeds from sale of loans
    14,869       9,943  
Originations of loans held for sale
    (14,012 )     (9,354 )
Loss on sale of other real estate owned and repossessed assets
    45       49  
Gain on sale of loans
    (34 )     (64 )
(Decrease) increase in operating assets and liabilities
               
Accrued interest receivable
    34       (32 )
Other assets
    928       (480 )
Accrued interest payable
    (26 )     (28 )
Other liabilities
    (922 )     (777 )
                 
Net cash provided (used) by from operating activities
    2,400       350  
                 
CASH FLOWS FROM INVESTING ACTIVITIES
               
Proceeds from maturities and sales of available for sale securities
    1,187       3,913  
Purchase of available for sale investments
    -       (5,832 )
Net increase in loans
    (3 )     (9,039 )
Improvements to OREO and other repossessed assets
    (30 )     -  
Proceeds from sale of OREO and other repossessed assets
    566       77  
Purchases of premises and equipment
    (13 )     (64 )
                 
Net cash provided (used) by investing activities
    1,707       (10,945 )
                 
CASH FLOWS FROM FINANCING ACTIVITIES
               
Net increase in deposits, net of acquired deposits
    (4,761 )     368  
Proceeds from borrowings
    28,000       17,100  
Repayment of borrowings
    (30,861 )     (17,100 )
Cash dividends paid
    -       (27 )
Net change in advances from borrowers for taxes and insurance
    157       233  
                 
Net cash provided (used) by financing activities
    (7,465 )     574  
                 
DECREASE IN CASH AND CASH EQUIVALENTS
    (3,358 )     (10,021 )
                 
CASH AND CASH EQUIVALENTS, beginning of period
    9,092       15,679  
                 
CASH AND CASH EQUIVALENTS, end of period
  $ 5,734     $ 5,658  

SUPPLEMENTAL CASH FLOW INFORMATION
           
    Cash paid for income taxes
  $ 220     $ 160  
    Interest paid on deposits and borrowings
  $ 778     $ 1,196  
    Net transfer of loans to other real estate owned
  $ 1,069     $ 647  

See notes to condensed consolidated financial statements

 
6
 
 


SOUND FINANCIAL, INC. AND SUBSIDIARY
Notes to Condensed Consolidated Financial Statement (unaudited)

Note 1 – Basis of Presentation

The accompanying financial information is unaudited and has been prepared from the consolidated financial statements of Sound Financial, Inc. (“we,” “us,” “our,” “Sound Financial,” or the “Company”) and its wholly owned subsidiary, Sound Community Bank (the “Bank”).  These condensed consolidated financial statements have been prepared in accordance with the instructions for Form 10-Q and Article 8 of Regulation S-X and do not include all disclosures required by U.S. generally accepted accounting principles (“GAAP”) for a complete presentation of the Company's financial condition and results of operations.  In the opinion of management, the information reflects all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation of the condensed consolidated financial statements in accordance with GAAP.  The results for the interim periods are not necessarily indicative of results for a full year.  For further information, refer to the consolidated financial statements and footnotes for the year ended December 31, 2010, included in the Company's Annual Report on Form 10-K.

Certain amounts in the prior quarters’ financial statements have been reclassified to conform to the current presentation.  These classifications do not have an impact on previously reported net income, retained earnings or earnings per share.

Note 2 – Accounting Pronouncements Recently Issued or Adopted

In December 2010, the FASB issued ASU No. 2010-29, Business Combinations (Topic 805): Disclosure of Supplementary Pro Forma Information for Business Combinations. This ASU requires that if a public entity discloses comparative financial statements, then those disclosures of revenue and earnings of the combined entity should be as though the business combination(s) that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only. The ASU also expands the supplemental pro forma disclosures under Topic 805 to include a description of the nature and amount of material, nonrecurring pro forma adjustments directly attributable to the business combination. The ASU is effective for business combinations that are consummated on or after the annual reporting period beginning on or after December 15, 2010. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.

In December 2010, the FASB issued ASU No. 2010-28, Intangibles—Goodwill and Other (Topic 350): When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts. This ASU modifies Step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. For those reporting units, an entity will be required to perform Step 2 of the goodwill impairment test if there are adverse qualitative factors that indicate that it is more likely than not that a goodwill impairment exists. For public reporting entities, the ASU is effective for interim and fiscal years beginning after December 15, 2010. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.

In April 2011, the FASB issued ASU No. 2011-02, “A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring” This ASU provides additional guidance related to determining whether a creditor has granted a concession, include factors and examples for creditors to consider in evaluating whether a restructuring results in a delay in payment that is insignificant, prohibit creditors from using the borrower’s effective rate test to evaluate whether a concession has been granted to the borrower, and add factors for creditors to use in determining whether a borrower is experiencing financial difficulties. A provision also ends the FASB’s deferral of the additional disclosures about TDRs as required by ASU 2010-20. The provisions of ASU 2011-02 are effective for the Company’s reporting period ending September 30, 2011. The adoption of this ASU is not expected to have a material impact on the Company’s consolidated financial statements.

 
7
 
 

SOUND FINANCIAL, INC. AND SUBSIDIARY
Notes to Condensed Consolidated Financial Statements (unaudited)

 
Note 3 – Fair Value Measurements

A description of the valuation methodologies used for certain financial assets and financial liabilities measured at fair value is as follows:

Mortgage Servicing Rights - The fair value of mortgage servicing rights is estimated using a discounted cash flow model based on market information from a third party. These assets are classified as Level 3.

AFS Securities – AFS securities are recorded at fair value based on quoted market prices, if available. If quoted market prices are not available, management utilizes third-party pricing services or broker quotations from dealers in the specific instruments. Level 1 securities include those traded on an active exchange, as well as U.S. government and its agencies securities. Level 2 securities include agency and non-agency mortgage-backed securities and certain collateralized mortgage obligations (CMOs).

Loans Held for Sale - Residential mortgage loans held for sale are recorded at the lower of cost or fair value. The fair value of fixed-rate residential loans is based on whole loan forward prices obtained from government sponsored enterprises. These loans are classified as Level 2 and are measured on a nonrecurring basis.  At March 31, 2011, loans held for sale were carried at cost.

Impaired Loans - The fair value of collateral dependent loans is based on the current appraised value of the collateral or internally developed models which contain management’s assumptions.  These assets are classified as level 3 and are measured on a nonrecurring basis.

Other Real Estate Owned (“OREO”) and Repossessed Assets - OREO and repossessed assets consist principally of properties acquired through foreclosure and are carried at the lower of cost or estimated market value less selling costs.  The fair value is based on current appraised value or other sources of value.

The following table presents the balances of assets measured at fair value on a recurring basis at March 31, 2011:

   
Fair Value at March 31, 2011
 
Description
 
Total
   
Level 1
   
Level 2
   
Level 3
 
   
(in thousands)
 
Mortgage Servicing Rights
  $ 3,146     $ -     $ -     $ 3,146  
Agency Mortgage-backed Securities
    61       -       61       -  
Non-agency Mortgage-backed Securities
    3,581       -       3,581       -  
       
   
Fair Value at December 31, 2010
 
Description
 
Total
   
Level 1
   
Level 2
   
Level 3
 
   
(in thousands)
 
Mortgage Servicing Rights
  $ 3,200     $ -     $ -     $ 3,200  
Agency Mortgage-backed Securities
    61       -       61       -  
Non-agency Mortgage-backed Securities
    4,480       -       4,480       -  

For the three months ended March 31, 2011 there were no transfers between level 1 and level 2 or between level 2 and level 3.

 
8
 
 


SOUND FINANCIAL, INC. AND SUBSIDIARY
Notes to Condensed Consolidated Financial Statements


The following table presents the balance of assets measured at fair value on a nonrecurring basis and the total losses resulting from these fair value adjustments:
 
      Fair Value at March 31, 2011  
Three Months Ended
March 31, 2011
 
Description
 
Total
   
Level 1
   
Level 2
   
Level 3
   
Total Losses
 
   
(in thousands)
 
Loans Held for Sale
  $ 79     $ -     $ 79     $ -     $ -  
OREO and Repossessed Assets
    3,113       -       -       3,113       45  
Impaired Loans
    11,246       -       -       11,246       38  

      Fair Value at December 31, 2010  
Year Ended December 31, 2010
 
Description
 
Total
   
Level 1
   
Level 2
   
Level 3
   
Total Losses
 
   
(in thousands)
 
Loans Held for Sale
  $ 902     $ -     $ 902     $ -     $ -  
OREO and Repossessed Assets
    2,625       -       -       2,625       461  
Impaired Loans
    11,730       -       -       11,730       3,944  

There were no liabilities carried at fair value, measured on a recurring or nonrecurring basis, at March 31, 2011 or December 31, 2010.

The following table provides a reconciliation of the assets and liabilities measured at fair value using significant unobservable inputs (Level 3) on a recurring basis during the three months ended March 31, 2011 and 2010:
 
   
Mortgage
Servicing
Rights
 
       
Beginning balance as of January 1, 2011
  $ 3,200  
         
Servicing rights that result from transfers of financial assets
    148  
Other changes in Fair Value
    (1 )
Net disposals of servicing rights
    (201 )
Transfers in and/or out of Level 3
    -  
         
Ending balance at March 31, 2011
  $ 3,146  

   
Mortgage
Servicing
Rights
 
       
Beginning balance at January 1, 2010
  $ 3,327  
Adoption of fair value option on mortgage servicing rights
    39  
Fair Value as of January 1, 2010
    3,366  
         
Servicing rights that result from transfers of financial assets
    99  
Other changes in Fair Value
    285  
Net disposals of servicing rights
    (136 )
Transfers in and/or out of Level 3
    -  
         
Ending balance at March 31, 2010
  $ 3,614  

 
9
 
 


SOUND FINANCIAL, INC. AND SUBSIDIARY
Notes to Condensed Consolidated Financial Statements

 
The estimated fair value of the Company’s financial instruments is summarized as follows:

   
March 31, 2011
   
December 31, 2010
 
   
Carrying
Amount
   
Fair
Value
   
Carrying
Amount
   
Fair
Value
 
Financial assets:
 
(in thousands)
 
 Cash and cash equivalents
  $ 5,734     $ 5,734     $ 9,092     $ 9,092  
 Available for sale securities
    3,642       3,642       4,541       4,541  
  FHLB Stock
    2,444       2,444       2,444       2,444  
 Loans held for sale
    79       79       902       902  
 Loans, net
    292,919       293,474       294,810       295,161  
 Accrued interest receivable
    1,246       1,246       1,280       1,280  
  Bank-owned life insurance
    6,791       6,791       6,729       6,729  
  Mortgage servicing rights,
  at fair value
    3,146       3,146       3,200       3,200  
                                 
Financial liabilities:
                               
Demand deposits
    151,494       151,494     $ 148,111     $ 148,111  
Time deposits
    122,239       123,126       130,383       131,503  
Borrowings
    21,988       22,021       24,849       24,624  
Accrued interest payable
    95       95       121       121  
Advance payments from
                               
borrowers for taxes
                               
and insurance
    409       409       252       252  

 
The following methods and assumptions were used to estimate fair value of each class of financial instruments listed below:
 
Cash and cash equivalents, accrued interest receivable and payable, and advance payments from borrowers for taxes and insurance - The estimated fair value is equal to the carrying amount.
 
Available for sale securities – Available for sale securities are recorded at fair value based on quoted market prices, if available. If quoted market prices are not available, management utilizes third-party pricing services or broker quotations from dealers in the specific instruments. Level 1 securities include those traded on an active exchange, as well as U.S. government and its agencies securities. Level 2 securities include private label mortgage-backed securities.

Loans - The estimated fair value for all fixed rate loans is determined by discounting the estimated cash flows using the current rate at which similar loans would be made to borrowers with similar credit ratings and maturities. The estimated fair value for variable rate loans is the carrying amount. The fair value for all loans also takes into account projected credit losses as a part of the estimate.

Loans Held for Sale - Residential mortgage loans held for sale are recorded at the lower of cost or fair value. The fair value of fixed-rate residential loans is based on whole loan forward prices obtained from government sponsored enterprises. At March 31, 2011, loans held for sale were carried at cost, which approximates fair value.
 

 
10
 
 


SOUND FINANCIAL, INC. AND SUBSIDIARY
Notes to Condensed Consolidated Financial Statements


Mortgage Servicing Rights - The fair value of mortgage servicing rights is estimated using a discounted cash flow model based on market information from a third party. These assets are classified as Level 3.

FHLB stock - The estimated fair value is equal to the par value of the stock, which approximates fair value.

Bank-owned Life Insurance - The estimated fair value is equal to the cash surrender value of policies, net of surrender charges.
 
Deposits - The estimated fair value of deposit accounts (savings, demand deposit, and money market accounts) is the carrying amount. The fair value of fixed-maturity time certificates of deposit are estimated by discounting the estimated cash flows using the current rate at which similar certificates would be issued.
 
Borrowings - The fair value of FHLB advances are estimated using discounted cash flow analyses, based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements.
 
Off-balance-sheet financial instruments - The fair value for the Company’s off-balance-sheet loan commitments are estimated based on fees charged to others to enter into similar agreements taking into account the remaining terms of the agreements and credit standing of the Company’s customers. The estimated fair value of these commitments is not significant.
 
We assume interest rate risk (the risk that general interest rate levels will change) as a result of our normal operations. As a result, the fair values of our financial instruments will change when interest rate levels change, which may be favorable or unfavorable to us. Management attempts to match maturities of assets and liabilities to the extent necessary or possible to minimize interest rate risk. However, borrowers with fixed-rate obligations are less likely to prepay in a rising rate environment and more likely to prepay in a falling rate environment. Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment. Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by establishing early withdrawal penalties for certificates of deposit, creating interest rate floors for certain variable rate loans, adjusting terms of new loans and deposits, by borrowing at fixed rates for fixed terms and investing in securities with terms that mitigate our overall interest rate risk.
 
 
Note 4 – Commitments and Contingencies
 
In the normal course of operations, the Company engages in a variety of financial transactions that are not recorded in our financial statements.  These transactions involve varying degrees of off-balance sheet credit, interest rate and liquidity risks.  These transactions are used primarily to manage customers’ requests for funding and take the form of loan commitments and lines of credit.
 

 
11
 
 


SOUND FINANCIAL, INC. AND SUBSIDIARY
Notes to Condensed Consolidated Financial Statements (unaudited)
 
Note 5 - VISA

In November 2007, Visa Inc. (“Visa”) announced that it had reached a settlement with American Express and Discover Card related to antitrust lawsuits. The Company and other Visa member banks were obligated to fund the settlement and share in losses resulting from this litigation.  The Company is not a party to the Visa litigation and its liability arises solely from the Company’s membership interest in Visa, Inc.  In the first quarter of 2008, Visa completed an initial public offering and the Company received $154,000 as part of a subsequent mandatory partial redemption of our Visa Class B shares.  Using the proceeds from this offering, Visa established a $3.0 billion escrow account to cover settlements, the resolution of pending litigation and related claims (“covered litigation”).
 
As of March 31, 2011, the Company owned 5,699 shares of Class B common stock.  These shares are restricted and may not be transferred until the later of (i) three years from the date of the initial public offering or (ii) the period of time necessary to resolve the covered litigation.  A conversion ratio of 0.71429 was initially established for the conversion rate of Class B shares into Class A shares.  If the funds in the escrow account are insufficient to settle all the covered litigation, Visa may sell additional Class A shares, use the proceeds to settle litigation, and further reduce the conversion ratio.  If funds remain in the escrow account after all litigation is settled, the Class B conversion ratio will be increased to reflect that surplus.  Since the litigation escrow account was established, Visa has deposited additional funds into the account.  This has resulted in a reduction in the conversion ratio from the initial ratio of 0.71429 to 0.4881 as of March 31, 2011.  Further reductions in the conversion ratio are possible before redemption.
 
As of March 31, 2011, the value of the Class A shares was $73.62 per share.  Using the current conversion ratio, the value of unredeemed Class A equivalent shares owned by the Company was $205,000 and has not been reflected in the accompanying consolidated financial statements.
 
Note 6 – Loans

The composition of the loan portfolio, excluding loans held for sale, was as follows:
 
   
March 31,
2011
   
December 31,
2010
 
One-to-four family loans
 
(in thousands)
 
First mortgages
  $ 100,060     $ 107,600  
Home equity
    44,842       44,829  
      144,902       152,429  
Commercial loans
               
Commercial real estate
    70,383       69,531  
Multifamily residential
    36,215       30,887  
Business term loans and lines of credit
    14,900       14,678  
      121,498       115,096  
Consumer loans
               
Manufactured housing
    19,556       20,043  
Auto and other consumer
    11,822       12,109  
      31,378       32,152  
                 
Total loans
    297,778       299,677  
                 
Deferred loan origination fees
    (443 )     (431 )
Allowance for loan losses
    (4,416 )     (4,436 )
Total loans, net
  $ 292,919     $ 294,810  


 
12
 
 


SOUND FINANCIAL, INC. AND SUBSIDIARY
Notes to Condensed Consolidated Financial Statements


The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on impairment method as of December 31, 2010:
 
    
One-to-
four family
first
mortgage(1)
   
One-to-four
family
home
equity
   
Commercial
real
estate(2)
   
Commercial
business
   
Multifamily
residential
   
Manufactured
housing
   
Auto and
other
consumer
   
Serviced(1)
   
Unallocated
   
Total
 
   
(In thousands)
 
Allowance for loan losses:
 
                                                             
Ending balance       863        1,405        1,300        209        -        287        197      65      90        4,416  
                                                                             
Ending balance:
individually evaluated
for impairment
    304       236       510       82       -       5       13      -      -       1,150  
                                                                             
Ending balance:
collectively evaluated
for impairment
    559       1,169       790       127       -       282       184       65       90       3,266  
                                                                                 
Loans receivable:
 
Ending balance
     100,060        44,842        70,383        14,900        36,215        19,556        11,822        -        -        297,778  
                                                                                 
Ending balance:
individually evaluated
for impairment
    5,055       1,327       4,272       333       -       117       142       -       -       11,246  
                                                                                 
Ending balance:
collectively evaluated
for impairment
    95,024       43,515       66,111       14,567       36,215       19,439       11,680       -       -       286,551  
                                                                                 
Ending balance:
loans acquired with
deteriorated credit
quality
    -               -       -       -       -       -       -       -       -  
___________________________
(1) One- to four- family mortgages includes approximately $8.3 million of residential land and construction loans.
(2) Commercial real estate includes approximately $4.8 million of commercial construction and development loans.
(3) Allowance established in 2010 for loans sold to Fannie Mae that we may be contractually obligated to repurchase.

 
The following table summarizes the activity in loan losses for the period ended March 31, 2011:
 
   
Beginning
                     
Ending
 
   
Allowance
   
Charge-offs
   
Recoveries
   
Provision
   
Allowance
 
   
(In thousands)
 
One- to four- family first mortgage
  $ 909     $ (242 )     12       185       863  
One- to four- family home equity
    1,480       (432 )     5       352       1,405  
Commercial real estate
    664       (70 )     -       706       1,300  
Commercial business
    163       -       -       46       209  
Multifamily residential
    -       -       -       -       -  
Manufactured housing
    294       -       -       (7 )     287  
Auto and other consumer
    309       (131 )     13       6       197  
Serviced
    65               -       -       65  
Unallocated
    553               -       (462 )     90  
    $ 4,436     $ (875 )   $ 30     $ 825     $ 4,416  

 
13
 
 


SOUND FINANCIAL, INC. AND SUBSIDIARY
Notes to Condensed Consolidated Financial Statements

 
Credit Quality Indicators.  Federal regulations provide for the classification of lower quality loans and other assets, such as debt and equity securities, as substandard, doubtful or loss.  An asset is considered substandard if it is inadequately protected by the current net worth and pay capacity of the borrower or of any collateral pledged.  Substandard assets include those characterized by the distinct possibility that we will sustain some loss if the deficiencies are not corrected.  Assets classified as doubtful have all the weaknesses of currently existing facts, conditions and values.  Assets classified as loss are those considered uncollectible and of such little value that their continuance as assets without establishment of a specific loss reserve is not warranted.
 
When we classify problem assets as either substandard or doubtful, we may establish a specific allowance in an amount we deem prudent to address the risk specifically or we may allow the loss to be addressed in the general allowance.  General allowances represent loss allowances which have been established to recognize the inherent risk associated with lending activities, but which, unlike specific allowances, have not been specifically allocated to particular problem assets.  When an insured institution classifies problem assets as a loss, it is required to charge off such assets in the period in which they are deemed uncollectible.  Assets that do not currently expose us to sufficient risk to warrant classification as substandard or doubtful but possess identified weaknesses are required to be classified as either watch or special mention assets.  Our determination as to the classification of our assets and the amount of our valuation allowances is subject to review by the OTS, which can order the establishment of additional loss allowances.
 
Early indicator loan grades are used to identify and track potential problem loans which do not rise to the levels described for substandard, doubtful or loss.  The grades for watch and special mention are assigned to loans which have been criticized based upon known characteristics such as periodic payment delinquency or stale financial information from the borrower and/or guarantors.  Loans identified as criticized (watch and special mention) or classified (substandard, doubtful, or loss) are subject to problem loan reporting not less than quarterly.
 
The following table represents the internally assigned grades as of March 31, 2011 by type of loan:
 
    
One-to-four
family first
mortgages
   
One-to-four
family home
equity
   
Commercial
Real Estate
   
Commercial
Business
   
Multifamily
residential
   
Manufactured
housing
   
Auto and other
consumer
   
Total
 
(in thousands)
 
Grade:
 
Pass
  $ 81,896     $ 40,499     $ 60,195     $ 11,206     $ 35,333     $ 17,577     $ 10,432     $ 257,138  
Watch
    14,066       3,506       5,916       3,347       882       1,806       1,218       30,741  
Special Mention
    1,447       124       2,043       169       -       53       67       3,903  
Substandard
    2,651       713       2,229       178       -       120       105       5,996  
Doubtful
    -       -       -       -       -       -       -       -  
Loss
    -       -       -       -       -       -       -       -  
                                                                 
Total
  $ 100,060     $ 44,842     $ 70,383     $ 14,900     $ 36,215     $ 19,556     $ 11,822     $ 297,778  

 
Nonaccrual and Past Due Loans.  Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due.  Loans are automatically placed on nonaccrual once the loan is 90 days past due or if, in management’s opinion, the borrower may be unable to meet payment of obligations as they become due, as well as when required by regulatory provisions.
 

 
14
 
 


SOUND FINANCIAL, INC. AND SUBSIDIARY
Notes to Condensed Consolidated Financial Statements

 
The following table represents the credit risk profile based on payment activity as of March 31, 2011 by type of loan:
 
    
One-to-four
family first
mortgages
   
One-to-four
family home
equity
   
Commercial
real estate
   
Commercial
business
   
Multifamily
residential
   
Manufactured
housing
   
Auto and other
consumer
   
Total
 
   
(in thousands)
 
   
Performing
  $ 96,608     $ 44,072     $ 68,786     $ 14,773     $ 36,215     $ 19,470     $ 11,741     $ 291,665  
Nonperforming
    3,452       770       1,597       127       -       86       81       6,113  
                                                                 
Total
  $ 100,060     $ 44,842     $ 70,383     $ 14,900     $ 36,215     $ 19,556     $ 11,822     $ 297,778  

 
The following table represents the aging of the recorded investment in past due loans as of March 31, 2011 by type of loan:

    
30-59 Days
Past Due
   
60-89 Days
Past Due
   
Greater Than 90
Days Past Due
   
Great Than 90
Days and
Accruing Interest
   
Total
Past Due
   
Current
   
Total Loans
 
   
(in thousands)
 
One-to-four family first mortgages
  $ 4,758     $ 857     $ 962     $ -     $ 6,577     $ 93,483     $ 100,060  
One-to-four family home equity
    845       415       222       -       1,482       43,360       44,842  
Commercial real estate
    -       -       -       -       -       70,383       70,383  
Commercial business
    -       178       -       -       178       14,722       14,900  
Multifamily residential
    -       -       -       -       -       36,215       36,215  
Manufactured housing
    324       55               -       379       19,177       19,556  
Auto and other consumer
    118       45               -       163       11,659       11,822  
                                                         
Total
  $ 6,045     $ 1,550     $ 1,184       -     $ 8,779     $ 288,999     $ 297,778  
                                                         

 
Impaired Loans.  A loan is considered impaired when we have determined that we may be unable to collect payments of principal or interest when due under the original terms of the loan.  In the process of identifying loans as impaired, we take into consideration factors which include payment history and status, collateral value, financial condition of the borrower, and the probability of collecting scheduled payments in the future.  Minor payment delays and insignificant payment shortfalls typically do not result in a loan being classified as impaired.  The significance of payment delays and shortfalls is considered on a case by case basis, after taking into consideration the totality of circumstances surrounding the loans and the borrowers, including payment history and amounts of any payment shortfall, length and reason for delay, and likelihood of return to stable performance.  Impairment is measured on a loan by loan basis for all loans in the portfolio.
 

 
15
 
 


SOUND FINANCIAL, INC. AND SUBSIDIARY
Notes to Condensed Consolidated Financial Statements

 
The following table presents loans individually evaluated for impairment as of March 31, 2011 by type of loan:

   
Recorded
Investment
   
Unpaid Principal Balance
   
Related
Allowance
   
Average
Recorded
Investment
   
Interest Income Recognized
 
   
(in thousands)
             
With no related allowance recorded:
             
One-to-four family first mortgages
  $ 2,047     $ 2,047       -     $ 1,731     $ 6  
One-to-four family home equity
    631       631       -       542       3  
Commercial real estate
    397       397       -       453       2  
Commercial business
    155       155       -       147       -  
Multifamily residential
    -       -       -       -       -  
Manufactured housing
    91       91       -       46       -  
Auto and other consumer
    87       87       -       55       -  
Total
  $ 3,408     $ 3,408       -     $ 2,972     $ 11  
                                         
With an allowance recorded:
                                       
One-to-four family first mortgages
    3,008       3,008       304       4,135       7  
One-to-four family home equity
    696       734       235       1,069       3  
Commercial real estate
    3,875       3,875       510       3,074       32  
Commercial business
    178       178       82       131       3  
Multifamily residential
    -       -       -       -       -  
Manufactured housing
    26       26       5       72       1  
Auto and other consumer
    55       55       13       35       -  
Total
  $ 7,838     $ 7,876     $ 1,150     $ 8,516     $ 46  
                                         
Totals:
                                       
One-to-four family first mortgages
    5,036       5,055       304       5,866       13  
One-to-four family home equity
    1,327       1,365       236       1,611       6  
Commercial real estate
    4,272       4,272       510       3,527       34  
Commercial Business
    333       333       82       278       3  
Multifamily residential
    -       -       -       -       -  
Manufactured Housing
    117       117       5       118       1  
Auto and other consumer
    142       142       13       90       -  
Total
  $ 11,246     $ 11,284     $ 1,150     $ 11,489     $ 57  
 
 
The following table presents the recorded investment in nonaccrual loans as of March 31, 2011 by type of loan:
 
   
Balance
 
   
(in thousands)
 
       
One-to-four family first mortgage
  $ 1,673  
One-to-four home equity
    393  
Manufactured housing
    86  
Auto and other consumer
    37  
Total
  $ 2,189  
         

 

 
16
 
 


SOUND FINANCIAL, INC. AND SUBSIDIARY
Notes to Condensed Consolidated Financial Statements

 
A summary of nonaccrual, impaired and troubled debt restructured loans is as follows:

   
March 31,
   
December 31,
 
   
2011
   
2010
 
   
(in thousands)
 
Total nonaccrual loans
  $ 2,189     $ 2,898  
Loans greater than 90 days past due and still accruing interest
    -       -  
Total impaired loans
    11,246       11,730  
Average investment in impaired loans
    11,488       13,386  
Forgone interest on non-accrual loans
    75       259  
Interest income recognized on impaired loans
    57       419  
Troubled debt restructured loans still on accrual
    3,924       4,396  
Troubled debt restructured loans included in impaired loans
    3,924       4,396  

The nonaccrual loans at March 31, 2011 consisted of $1.7 million in one-to four- family mortgage loans, $393,000 in home equity lines of credit, and 123,000 in other consumer loans.  There were no commitments to lend additional funds to borrowers whose loans were classified as nonaccrual or impaired at March 31, 2011.

The non-accrual loans at December 31, 2010 consisted of $2.6 million in one- to four-family mortgage loans and $341,000 in home equity loans.  There were no commitments to lend additional funds to borrowers whose loans were classified as non-accrual or impaired at December 31, 2010.

 
17
 
 

SOUND FINANCIAL, INC. AND SUBSIDIARY
Notes to Condensed Consolidated Financial Statements (unaudited)
 
Note 7 – Investments
 
The amortized cost and fair value of our AFS securities and the corresponding amounts of gross unrealized gains and losses were as follows:
 
         
Gross Unrealized
       
   
Amortized
Cost
   
Gains
   
Losses 1 Year
or Less
   
Losses Greater
Than 1 Year
   
Estimated
Fair
Value
 
 
 
March 31, 2011
 
(in thousands)
 
Agency mortgage-backed securities
  $ 54     $ 7     $ -     $ -     $ 61  
Non-agency mortgage-backed securities
    4,284       -       -     $ (703 )     3,581  
     Total
  $ 4,338     $ 7     $ -     $ (703 )   $ 3,642  
                                         
December 31, 2010
 
(in thousands)
 
Agency mortgage-backed securities
  $ 54     $ 7     $ -     $ -     $ 61  
Non-agency mortgage-backed securities
    5,543       2       -       (1,065 )     4,480  
     Total
  $ 5,597     $ 9     $ -     $ (1,065 )   $ 4,541  
                                         

The amortized cost and fair value of mortgage-backed securities by contractual maturity, at March 31, 2011, are shown below.  Expected maturities of mortgage-backed securities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

   
March 31, 2011
 
   
Amortized Cost
   
Fair Value
 
   
(in thousands)
 
Due within one year
  $ -     $ -  
Due after one year through five years
    -       -  
Due after five years through ten years
    -       -  
Due after ten years
    4,338       3,642  
    $ 4,338     $ 3,642  

Securities with an amortized cost of $54,000 and fair value of $61,000 at March 31, 2011 were pledged to secure Washington State Public Funds.  Additionally, the Company has letters of credit with a notional amount of $12.0 million to secure public deposits.

Sales of available for sale securities were as follows:

   
Three Months Ended March 31,
 
   
2011
   
2010
 
   
(in thousands)
 
Proceeds
  $ 1,096     $ 3,371  
Gross gains
    3       75  
Gross losses
    (37 )     -  

 
18
 
 


SOUND FINANCIAL, INC. AND SUBSIDIARY
Notes to Condensed Consolidated Financial Statements (unaudited)
 
The following table summarizes the aggregate fair value and gross unrealized loss by length of time those investments have been continuously in an unrealized loss position:
 
   
March 31, 2011
 
   
Less Than 12 Months
   
12 Months or Longer
   
Total
 
   
Fair Value
   
Unrealized Loss
   
Fair Value
   
Unrealized Loss
   
Fair Value
   
Unrealized Loss
 
March 31, 2011
 
(in thousands)
 
Non-agency mortgage-
backed securities
  $ -     $ -     $ 3,581     $ (703 )   $ 3,581     $ (703 )
Total
  $ -     $ -     $ 3,581     $ (703 )   $ 3,581     $ (703 )
                                                 
   
December 31, 2010
 
   
Less Than 12 Months
   
12 Months or Longer
   
Total
 
   
Fair Value
   
Unrealized Loss
   
Fair Value
   
Unrealized Loss
   
Fair Value
   
Unrealized Loss
 
December 31, 2010
 
(in thousands)
 
Non-agency mortgage-
backed securities
  $ -     $ -     $ 3,842     $ (1,065 )   $ 3,842     $ (1,065 )
Total
  $ -     $ -     $ 3,842     $ (1,065 )   $ 3,842     $ (1,065 )


The following table presents the OTTI losses for the three month periods ended March 31, 2011 and 2010:

   
Three Months Ended
 
   
March 31,
 
   
2011
   
2010
 
   
(in thousands)
 
Total other-than-temporary impairment losses
  $ 39     $ -  
Portion of other-than-temporary impairment losses recognized in
other comprehensive income (before taxes)
    -       -  
Net impairment losses recognized in earnings
  $ 39     $ -  
 
 
The following table presents the cumulative roll forward of credit losses recognized in earnings relating to the Company’s non-U.S. agency mortgage backed securities:

   
Three Months Ended
 
   
March 31,
 
   
2011
   
2010
 
   
(in thousands)
 
Estimated credit losses, beginning balance
  $ 160     $ 61  
Additions for credit losses not previously recognized
    39       -  
Reduction for increases in cash flows
    -       -  
Reduction for realized losses
    -       -  
Estimated losses, ending balance
  $ 199     $ 61  
 

As of March 31, 2011, our securities portfolio consisted of two U.S.-agency and five non-U.S. agency mortgage backed securities with a fair value of $3.6 million, of which, all non-U.S. agency securities were in an unrealized loss position.  The unrealized losses were caused by changes in interest rates and market illiquidity causing a decline in the fair value subsequent to the purchase.

 
19
 
 

SOUND FINANCIAL, INC. AND SUBSIDIARY
Notes to Condensed Consolidated Financial Statements (unaudited)
 

While management does not intend to sell the non-agency mortgage backed securities, nor is it more likely than not that the Company will be required to sell these securities before recovery of its amortized cost basis, management’s impairment evaluation indicates that certain securities possess qualitative and quantitative factors that suggest OTTI. These factors include, but are not limited to: the length of time and extent of the fair value declines, ratings agency down grades, the potential for an increased level of actual defaults, and the extension in duration of the securities. In addition to the qualitative factors, management’s evaluation includes an assessment of quantitative evidence that involves the use of cash flow modeling and present value calculations as determined by considering the applicable OTTI accounting guidance. The Company compares the present value of the current estimated cash flows to the present value of the previously estimated cash flows. Accordingly, if the present value of the current estimated cash flows is less than the present value of the previous period’s present value, an adverse change is considered to exist and the security is considered OTTI. The associated “credit loss” is determined as the amount by which the security’s amortized cost exceeds the present value of the current estimated cash flows. Based upon the results of the cash flow modeling as of March 31, 2011, one security reflected OTTI during the period. Estimating the expected cash flows and determining the present values of the cash flows involves the use of a variety of assumptions and complex modeling. In developing its assumptions, the Company considers all available information relevant to the collectability of the applicable security, including information about past events, current conditions, and reasonable and supportable forecasts. Furthermore, the Company asserts that the cash flows used in the determination of OTTI are its “best estimate” of cash flows.

The Company engages a third party to perform the cash flow model. The model includes each individual non-agency mortgage backed securities’ structural features. The modeled cash flows are discounted back and they incorporate additional projected defaults based upon risk analysis of the financial condition and performance. Utilizing the quantitative change in the net present value of the cash flows compared to the amortized cost of the security, the Company recognized additional credit losses of $39,000 in non-cash pre-tax impairment charges for the three months ended March 31, 2011. Cumulative at March 31, 2011, the Company has recognized a total of $199,000 of OTTI on three of the five non-agency mortgage backed securities.
 
Note 8 – Mortgage Servicing Rights
 
The unpaid principal balances of loans serviced for Federal National Mortgage Association (FNMA) at March 31, 2011 totaled approximately $430.9 million, and are not included in the Company’s financial statements.
 
 
The change in the mortgage servicing asset is summarized below (in thousands):
 
Beginning balance as of January 1, 2011
  $ 3,200  
Additions:
       
Servicing rights that result from transfers of financial assets
    148  
Other changes in Fair Value
    (1 )
Subtractions:
       
Net disposals of servicing obligations
    (201 )
Fair Value as of March 31, 2011
  $ 3,146  
 

 
20
 
 

SOUND FINANCIAL, INC. AND SUBSIDIARY
Notes to Condensed Consolidated Financial Statements (unaudited)
 
 
Note 9 – Borrowings
 
The Company utilizes a loan agreement with the FHLB of Seattle. The terms of the agreement call for a blanket pledge of a portion of the Company’s mortgage and commercial real estate portfolio based on the outstanding balance. At March 31, 2011, the amount available to borrow under this agreement is approximately 35% of total assets, or up to $114.4 million, subject to the availability of eligible collateral. The Company had outstanding borrowings under this arrangement of $22.0 million and $24.8 million at March 31, 2011 and December 31, 2010, respectively.
 
The Company participates in the Federal Reserve Bank’s Borrower-in-Custody program, which gives the Company access to overnight borrowings from the discount window.  The terms of the program call for a pledge of specific assets.  The Company had unused borrowing capacity under this program of $24.8 million and $24.9 million at March 31, 2011 and December 31, 2010, respectively.  There were no outstanding borrowings at March 31, 2011 or December 31, 2010.

The Company has access to an unsecured line of credit from the Pacific Coast Banker’s Bank.  This line of credit is equal to $2.0 million as of March 31, 2010.  The line has a one-year term and is renewable annually.  There was no outstanding balance on this line of credit as of March 31, 2011 and December 31, 2010.
 
 
Note 10 – Earnings Per Share

Earnings per share are summarized in the following table (all figures are in thousands except earnings per share):

   
Three months ended March 31,
 
   
2011
   
2010
 
Net income
  $ 496     $ 57  
                 
Weighted average number of shares outstanding, basic
    2,921       2,909  
Effect of dilutive stock options
    -       -  
Weighted average number of shares outstanding, diluted
    2,921       2,909  
Earnings per share, basic
  $ 0.17     $ 0.02  
Earnings per share, diluted
  $ 0.17     $ 0.02  

For the three month periods ended March 31, 2011 and 2010, there were no anti-dilutive securities included in the calculation for earnings per share.
 
Note 11 – Stock-based Compensation
 
Stock Options and Restricted Stock

In 2008, the Board of Directors adopted and shareholders approved an Equity Incentive Plan (the “Plan”).  The plan permits the grant of restricted stock units, stock options, and stock appreciation rights. Under the Plan, 144,455 shares of common stock were approved for awards for stock options and stock appreciation rights and 57,782 shares of common stock were approved for awards for restricted stock and restricted stock units.
 
On January 27, 2009, the Compensation Committee of the Board of Directors of the Company awarded shares of restricted stock and stock options to directors, executive officers and employees of the Company and the Bank, pursuant to the Plan. The Company granted 25,998 non-qualified stock options and 82,400 incentive stock options to certain directors and employees.  The Company also granted 52,032 shares of restricted stock to certain directors and employees. During the period ended March 31, 2011, share based compensation expense totaled $33,000 for both the stock options and restricted stock.  All of the awards vest in 20 percent annual increments commencing one year from the grant date. The options are exercisable for a period of 10 years from the date of grant, subject to vesting. Half of the stock options granted to each of the award recipients were at an exercise price of $7.35, which was the fair market value of the Company’s common stock on the grant date. The remaining half of the stock options granted to each of the award recipients were at an exercise price of $8.50, which was $1.15 above the fair market value of the Company’s common stock on the grant date. The vesting date for options and restricted stock is accelerated in the event of the grantee’s death, disability or a change in control of the Company.

There were 21,680 exercisable stock options as of March 31, 2011. The aggregate intrinsic value of the stock options as of March 31, 2011 was $1,000.


 
21
 
 


SOUND FINANCIAL, INC. AND SUBSIDIARY
Notes to Condensed Consolidated Financial Statements (unaudited)
 
 
The following is a summary of the Company’s stock option plan awards during the period ended March 31, 2011:

   
Shares
   
Weighted-
Average
Exercise
Price
   
Weighted-Average Remaining Contractual Term In Years
   
Aggregate
Intrinsic
Value
 
Outstanding at the beginning of the year
    108,398     $ 7.93       8.34     $ -  
Granted
            -                  
Exercised
    -       -                  
Forfeited or expired
    -       -                  
Outstanding at March 31, 2011
    108,398     $ 7.93       7.83     $ -  
Exercisable
    21,680     $ 7.93       7.83     $ -  
Expected to vest, assuming a 0%
forfeiture rate over the vesting term
    108,398     $ 7.93       7.83     $ -  

As of March 31, 2011, there was $158,000 of total unrecognized compensation cost related to nonvested stock options granted under the Plan.  The cost is expected to be recognized over the remaining weighted-average vesting period of 2.83 years.

Restricted Stock Awards
 
The fair value of the restricted stock awards is equal to the fair value of the Company’s stock at the date of grant. Compensation expense is recognized over the vesting period that the awards are based. Shares awarded as restricted stock vest ratably over a five-year period beginning at the grant date with 20% vesting on the anniversary date of each grant date.
 
The following is a summary of the Company’s nonvested restricted stock awards for the period ended March 31, 2011:
 
 
 
Nonvested Shares
 
 
 
Shares
   
Weighted-
Average Grant-
Date Fair Value
   
Aggregate
Intrinsic Value
 
                   
Non-vested at January 1, 2011
    41,626     $ 7.35        
Granted
    -       -        
Vested
    10,406     $ 7.35        
Forfeited
    -       -        
Non-vested at March 31, 2011
    31,220     $ 7.35     $ 7.50  
                         
Expected to vest assuming a 0%
forfeiture rate over the vesting term
    31,220     $ 7.35     $ 7.50  

            The aggregate intrinsic value of the nonvested restricted stock options as of March 31, 2011 was $234,000.

As of March 31, 2011, there was $217,000 of unrecognized compensation cost related to non-vested restricted stock granted under the Plan remaining.  The cost is expected to be recognized over the weighted-average vesting period of 2.83 years.

In November 2008, the Board of Directors authorized management to repurchase up to 57,782 shares of the Company’s outstanding stock over a twelve-month period in order to fund the restricted stock awards made under the Plan, of which 45,800 shares were repurchased.
Employee Stock Ownership Plan

In January 2008, the ESOP borrowed $1,155,600 from the Company to purchase common stock of the Company. The loan is being repaid principally from the Company’s contributions to the ESOP over a period of ten years. The interest rate on the loan is fixed at 4.0% per annum.  As of March 31, 2011, the remaining balance of the ESOP loan was $858,000.  Neither the loan nor the related interest is reflected on the consolidated financial statements.

At March 31, 2011, the ESOP was committed to release 11,556 shares of the Company’s common stock to participants and held 80,892 unallocated shares remaining to be released in future years.  The fair value of the 80,892 restricted shares held by the ESOP trust was $607,000 at March 31, 2011.  ESOP compensation expense included in salaries and benefits was $19,000 for the three month period ended March 31, 2011.

 
22
 
 


Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operation
 
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
General
 
Sound Financial, Inc. (the “Company”) is the holding company and sole owner of Sound Community Bank (the “Bank”).  Sound MHC, a mutual holding company, owns 55% of the outstanding stock of the Company.  The Management Discussion and Analysis in Item 7 of the Company’s Form 10-K Annual Report filed with the SEC on March 31, 2011 contains an overview of the Company’s and the Bank’s business and history under the heading “General.”  This discussion updates that disclosure for the first quarter of 2011.
 
During the first quarter of 2011, the Company continued to encounter a number of challenges but also met a number of its goals.  Our market area continues to struggle economically, particularly with high unemployment levels and falling housing prices, which has resulted in higher levels of loan delinquencies, problem assets and foreclosures, decreased demand for our products and services and a decline in the value of our loan collateral.  If market conditions continue or become more severe, this negative impact on our business, financial condition and earnings may increase.  Even under these economic conditions, we were able to meet our goal of diversifying our loan portfolio by expanding our commercial real estate and multifamily lending business.  The Company has continued to focus on expanding its commercial business and commercial real estate loan portfolio, which has grown to $121.5 million or 41.5% of our net loan portfolio at March 31, 2011, compared to $115.1 million or 39.0% of our net loan portfolio at December 31, 2010.   The primary driver of the growth of our commercial real estate portfolio has been multifamily loans, which has grown to $36.2 million, or 12.4%, of our net loan portfolio at March 31, 2011, compared to $30.9 million, or 10.5%, of our net loan portfolio at December 31, 2010.  The increased level of commercial business, commercial real estate and multifamily loans has had a positive impact on our net interest income and has helped to further diversify our loan portfolio mix.
 
In addition, we originated $13.2 million and $16.0 million in one- to four-family residential mortgage loans during the quarters ended March 31, 2011and 2010, respectively.  During those same periods, we sold $15.0 million and $9.8 million, respectively, of those loans to Fannie Mae with servicing retained.  The decreased one- to four-family residential mortgage loan originations in the 2011 quarter reflects lower consumer demand in the marketplace, especially for refinancing.  The increase in sold loans in the 2011 quarter reflects normal loan sales as well as a one-time bulk sale of a portion of the Company’s residential loan portfolio.  This was sold to manage the size of the Company’s balance sheet as well as generate additional funds to lend to borrowers.
 
As reported in its Form 10-K Annual Report for the year ended December 31, 2010, the Company and the Bank each are under a Memorandum of Understanding (“MOU”) with the OTS to address the regulator’s concerns about certain deficiencies or weaknesses at the Bank.  The Board of Directors continues to believe that the MOU’s will not, fundamentally constrain the Bank’s or the Company’s business and that compliance has been achieved.  Under its MOU, the Bank has committed to achieving by March 31, 2011, and, thereafter, maintaining an 8.0% core capital ratio and a 12.0% total risk-based capital ratio, after funding an adequate allowance for loan and lease losses.  In order to achieve these capital ratios, the Company continued  to reduce its operating expenses, improve earnings levels and reduce asset size.  At March 31, 2011, the Bank’s core and total risk-based capital ratios were 8.25% and 12.12%, respectively.  See “- Capital.”  Management believes that the Bank will continue to meet the required capital ratios for the remainder of 2011.  The Bank is in compliance with the additional requirements in the MOU and, as required by the MOU, continued to decrease the level of its classified assets during the quarter ended March 31, 2011.  The Company believes it is in compliance with the requirements in its MOU, which include a prohibition on declaring or paying any cash dividends or redeeming any Company stock without OTS approval, not accepting any dividends from the Bank or any other payments that would reduce the capital of the Bank, and not increase or renew any debt on an unconsolidated basis without OTS approval.
 

 
23
 
 

Critical Accounting Policies

We consider accounting policies involving significant judgments and assumptions by management that have, or could have, a material impact on the carrying value of certain assets or on income to be critical accounting policies. We consider our critical accounting policies to be those related to our allowance for loan losses, mortgage serving rights, other real estate owned, and deferred tax asset accounts.  The allowance for loan losses is maintained to cover losses that are probable and can be estimated on the date of the evaluation in accordance with U.S. generally accepted accounting principles.  It is management’s best estimate of probable incurred credit losses in our loan portfolio.  Our methodologies for analyzing the allowance for loan losses, mortgage serving rights, other real estate owned and deferred tax asset accounts are described in our Form 10-K Annual Report for the year ended December 31, 2010.
 
Business and Operating Strategies and Goals
 
The Management Discussion and Analysis in Item 7 of the Company’s Form 10-K Annual Report filed with the SEC on March 31, 2011 contains an overview of the Company’s and the Bank’s business and operating strategies and goals.  This discussion updates that disclosure for the first quarter of 2011.
 
Continue to grow capital through improved earnings.  Through asset mix management and pricing and lower cost funds, we will seek to optimize our interest rate margin while managing our interest rate risk.  Our net interest income during the first quarter of 2011 was higher than the level during the first quarter of 2010.  We will seek new sources of non-interest income by emphasizing selective products and services that provide diversification of revenue sources, including interest income, fees and servicing income, though our noninterest income during the first quarter of 2011 was lower than the level during the first quarter of 2010.  We also will continue to manage operating expenses while continuing to provide superior personal service to our customers.  Operating expenses were lower than during the first quarter of 2011 compared to the first quarter of 2010.  Finally, our provision for loan losses was lower in the first quarter of 2011 than in the first quarter of 2010, reflecting some improvement in the economy both nationally and in the markets where we do business.  The Bank achieved net income of $496,000 in the first quarter of 2011 compared to $57,000 in the first quarter of 2010.
 
Emphasizing lower cost core deposits to reduce the funding costs of our loan growth.  Our weighted average cost of funds was 50 basis points lower in the first quarter of 2011 compared to the first quarter of 2010.  This decrease was the result of lower market rates on deposits and a higher percentage of deposits in low or noninterest-bearing accounts during the quarter.
 
Maintaining high asset quality.  We have worked to improve asset quality that declined in recent years due to declining economic conditions.  Our percentage of non-performing assets to total assets decreased to 2.76% at March 31, 2011 from 2.96% at December 31, 2010.  At the same time, net charge-offs to average loans outstanding decreased to 1.14% for the first quarter of 2011 compared to 1.31% during the fourth quarter of 2010.
 
Comparison of Financial Condition at March 31, 2011 and December 31, 2010
 
General.  Total assets decreased by $7.6 million, or 2.3%, to $327.0 million at March 31, 2011 from $334.6 million at December 31, 2010.  This decrease consisted primarily of a $4.3 million, or 31.2% decrease in cash and securities available for sale and a $1.9 million, or 0.6% decrease in loans receivable.
 

 
24
 
 

Cash and Securities.  We decreased our liquidity position significantly during the quarter ended March 31, 2011 because improvements in the local economy no longer required the higher level of on-balance sheet liquidity and because of the Company’s access to significant off-balance sheet sources of liquidity.  Cash, cash equivalents and our available-for-sale securities decreased $4.3 million, or 31.2%, to $9.4 million at March 31, 2011.  Cash and cash equivalents decreased by $3.4 million, or 36.9%, to $5.7 million at March 31, 2011, as the Company allowed certain out of market public deposits and higher cost of fund non-relationship deposits to runoff.  Available-for-sale securities, which consist primarily of non-agency mortgage-backed securities, decreased by $899,000, or 19.8%, to $3.6 million at March 31, 2011.  This decrease reflects investment sales, paydowns and other-than-temporary impairment on our non-agency mortgage-backed security portfolio.
 
At March 31, 2011, our available-for-sale securities portfolio consisted of $61,000 in U.S.-agency and $3.6 million in non-agency mortgage backed securities, of which, all five non-U.S. agency securities were in an unrealized loss position.  The unrealized losses are the result of changes in interest rates and market illiquidity that caused a decline in the fair value of these securities since they were purchased.  Non-U.S. agency securities present a higher credit risk than U.S. agency mortgage-backed securities.  In order to monitor the increased risk, management receives and reviews a credit surveillance report from a third party quarterly which evaluates these securities based on a number of factors, including original credit scores, loan-to-value ratios, geographic locations, delinquencies and loss histories of the underlying mortgage loans, in order to project future losses based on various home price depreciation scenarios over a three-year horizon.  Based on these reports, management ascertains the appropriate value for these securities and, in the first quarter of 2011, recorded an other-than-temporary impairment charge of $39,000 on one of these non-agency securities.  The current market environment significantly limits our ability to mitigate our exposure to value changes in these more risky securities by selling them, and we do not anticipate these conditions changing significantly during the remainder of 2011.  Accordingly, if the market and economic environment impacting the loans supported these securities continue to deteriorate, we could determine that an other-than-temporary impairment must be recorded on these securities, as well as on any other securities in our portfolio, our future earnings, equity, regulatory capital and ongoing operations could be materially adversely affected.
 
Our investment portfolio at March 31, 2011, also included $2.4 million in Federal Home Loan Bank stock, which we are required to own in order to obtain advances from the Federal Home Loan Bank of Seattle.  Federal Home Loan Bank stock is carried at par and does not have a readily determinable fair value.  Ownership of Federal Home Loan Bank stock is restricted to the Federal Home Loan Bank member institutions, and can only be purchased and redeemed at par of $100.  Due to ongoing turmoil in the capital and mortgage markets, the Federal Home Loan Bank of Seattle has a risk-based capital deficiency largely as a result of write-downs on its private label mortgage-backed securities portfolios.  Management evaluates our Federal Home Loan Bank stock for potential impairment.  Management’s determination of whether this investment is impaired is based on its assessment of the ultimate recoverability of cost rather than by recognizing temporary declines in value.  The determination of whether a decline affects the ultimate recoverability of cost is influenced by criteria such as:  (1) the significance of any decline in net assets of the Federal Home Loan Bank as compared to the capital stock amount for the Federal Home Loan Bank and the length of time this situation has persisted; (2) commitments by the Federal Home Loan Bank to make payments required by law or regulation and the level of such payments in relation to the operating performance of the Federal Home Loan Bank; (3) the impact of legislative and regulatory changes on institutions and, accordingly, the customer base of the Federal Home Loan Bank; and (4) the liquidity position of the Federal Home Loan Bank.  Under Federal Housing Finance Agency regulations, a Federal Home Loan Bank that fails to meet any regulatory capital requirement may not declare a dividend or redeem or repurchase capital stock in excess of what is required for members’ current loans.  The Federal Home Loan Bank of Seattle has announced that it had as of December 31, 2008 and continues to have a risk-based capital deficiency under those regulations and, as a result, has suspended future dividends and the repurchase or redemption of its common stock.  Therefore, we have received no dividends on our Federal Home Loan Bank stock since 2008.  The Federal Home Loan Bank of Seattle has communicated that it believes the calculation of its risk-based capital under applicable regulations overstates the market risk of its non-agency mortgage-backed securities and that it has enough capital to cover the risks reflected in its balance sheet.  In addition, according to Standard and Poor’s analysis of the Federal Home Loan Banks, the Federal Home Loan Bank System has a special public status (organized under the Federal Home Loan Bank Act of 1932) and may receive extraordinary support from the U.S. Treasury in a crisis.  Therefore, the Federal Home Loan Banks can be considered an extension of the government and the U.S. government would almost certainly support the credit obligations of the Federal Home Loan Bank system.  Based on this, we have determined there is not an other-than-temporary impairment on our Federal Home Loan Bank stock investment as of March 31, 2011.  However, continued deterioration in the Federal Home Loan Bank of Seattle’s financial condition may result in
 

 
25
 
 


 
impairment in the value of our Federal Home Loan Bank stock.  On October 25, 2010, the Federal Home Loan Bank entered into a consent order with its primary regulator; however, the impact of that order on its conditions or operations over time is unknown.  We will continue to monitor the financial condition of the Federal Home Loan Bank as it relates to, among other things, the recoverability of our investment in its stock.
 
Loans.  Our gross loan portfolio, including loans held for sale, decreased $2.7 million, or 0.9%, from $300.1 million at December 31, 2010 to $297.4 million at March 31, 2011.  Loans held for sale decreased from $902,000 at December 31, 2010, to $79,000 at March 31, 2011, reflecting primarily the timing of transactions at the end of the quarter, as compared to the end of 2010.
 
The following table reflects the changes in the types of loans in our gross loan portfolio at March 31, 2011 as compared to the end of 2010.
 
                         
   
At March 31,
2011
   
At December
31, 2010
   
Amount
Change
   
Percent
Change
 
   
(Dollar amounts in thousands)
 
Residential mortgages
  $ 100,060     $ 107,600     $ (7,540 )     -7.0 %
Home equity
    44,842       44,829       13       0.0 %
Multifamily mortgages
    36,215       30,887       5,328       17.3 %
Commercial real estate
    70,383       69,531       852       1.2 %
Commercial business
    14,900       14,678       222       1.5 %
Consumer
    31,378       32,152       (774 )     -2.4 %
  Deferred loan fees
    (443 )     (431 )     (12 )     -2.8 %
  Total
  $ 297,335     $ 299,246     $ (1,911 )     -0.6 %

The most significant changes in our loan portfolio during the quarter consist of increases in multifamily loans and decreases in residential mortgages.  The increase in multifamily housing loans is consistent with our operating strategy of growing and diversifying our loan portfolio.  The decrease in residential mortgages primarily reflects a $4.7 million bulk sale of seasoned residential mortgages to Fannie Mae with servicing retained coupled with lower overall consumer demand, particularly in refinancing.
 
Mortgage Servicing Rights.  At March 31, 2011, we had $3.1 million in mortgage servicing rights recorded at fair value, compared to $3.2 million at December 31, 2010.  We estimate the fair value of our mortgage servicing rights using a discounted cash flow model based on market information from a third party.  We record mortgage servicing rights on loans sold to Fannie Mae with servicing retained.  The Bank stratifies its capitalized mortgage servicing rights based on the type, term and interest rates of the underlying loans.  None of our mortgage servicing rights are deemed impaired; however, if they were determined to be impaired in the future, our financial results would be impacted.
 
Delinquencies and Non-performing Assets.  As of March 31, 2011, our total loans delinquent for 60 to 89 days was $1.2 million or 0.41% of gross loans, compared to $507,000 or 0.17% of gross loans at December 31, 2010.
 
At March 31, 2011, our nonperforming assets totaled $9.2 million, or 2.8% of total assets, compared to $9.9 million, or 3.0% of total assets at December 31, 2010.  This $693,000, or 7.0% decrease is the result of increased credit administration efforts, which was offset by $488,000 increase in OREO and other repossessed assets acquired during the quarter.  Net charge-offs decreased $138,000, or 14.0%, to $846,000 from $984,000 in the fourth quarter of 2010.
 

 
26
 
 

The table below sets forth the amounts and categories of non-performing assets in our loan portfolio at the dates indicated.
 
   
Non-performing Assets,
 
   
March 31,
2011
   
December 31,
2010
   
Amount
Change
   
Percent
Change
 
   
(Dollar amounts in thousands)
 
Nonaccruing loans
  $ 2,189     $ 2,898     $ (709 )     -24.5 %
Accruing loans 90 days or more
    delinquent
    --       --       --       --  
Restructured loans
    3,924       4,396       (472 )     -10.7 %
Foreclosed and repossessed assets
    3,113       2,625       488       18.6 %
Nonperforming investments
    --       --       --       --  
Total
  $ 9,226     $ 9,919     $ (693 )     -7.0 %

Non-performing loans to total loans decreased to 2.1% of gross loans at March 31, 2011, from 2.4% at the end of 2010.  This decrease reflects lower levels of restructured loans and lower nonaccruing loans.  Our largest non-performing assets at March 31, 2011, consisted of an $860,000 commercial development loan secured by a mobile home park, a $427,000 commercial real estate loan secured by a commercial building and a $333,000 mortgage loan secured by a single family residence.  We do not expect any material losses on these nonperforming assets in 2011.  We had no other non-performing loans in excess of $310,000 at March 31, 2011.
 
Foreclosed and repossessed assets increased during the quarter, from $2.6 million at the end of 2010 to $3.1 million at March 31, 2011, primarily due to depressed economic conditions in our market.  During the quarter ended March 31, 2011, we repossessed six personal residences and four repossessed assets, including manufactured homes and automobiles, and we sold or released interest in three personal residences and one other repossessed assets at an aggregate loss of $139,000.
 
In addition to the non-performing assets set forth in the table above, as of March 31, 2011, there was an aggregate of $5.1 million in loans with respect to which known information about the possible credit problems of the borrowers have caused management to have doubts as to the abilities of the borrowers to comply with present loan repayment terms and which may result in the future inclusion of such items in the non-performing asset categories.  Due to current economic conditions, we have seen a $679,000 increase in the amount of these loans since the end of 2010.
 
Allowance for Loan Losses.  The allowance for loan losses is maintained to cover losses that are probable and can be estimated on the date of the evaluation in accordance with generally accepted accounting principles in the United States.  It is our estimate of probable incurred credit losses in our loan portfolio.
 
Our methodology for analyzing the allowance for loan losses consists of specific and general components.  We stratify the loan portfolio into homogeneous groups of loans that possess similar loss-potential characteristics and apply an appropriate loss ratio to the homogeneous pools of loans to estimate the incurred losses in the loan portfolio.  The amount of loan losses incurred in our consumer portfolio is estimated by using historical loss ratios for major loan collateral types adjusted for current factors.  The historical loss experience is generally defined as an average percentage of net loan losses to loans outstanding.  A separate valuation of known losses for individual classified large-balance, non-homogeneous loans is also conducted.  The allowance for loan losses on individually analyzed loans includes commercial business loans and one- to four-family and commercial real estate loans, where management has concerns about the borrower’s ability to repay.  Loss estimates include the difference between the current fair value of the collateral and the loan amount due.
 
Our allowance for loan losses at March 31, 2011, was $4.4 million, or 1.49% of gross loans receivable, compared to $4.4 million, or 1.48% of net loans receivable at December 31, 2010.  This reflects the $825,000 provision for loan losses established during the quarter, as a result of increases in our commercial loan portfolios over the three months and an evaluation of declining housing and other market conditions in our market area, and the $845,000 in net charge-offs on non-performing loans during the quarter.
 

 
27
 
 


 
The following table shows the adjustments in our allowance during the first quarter of 2011 as compared to the first quarter of 2010:
 
   
At and for the Period Ended March 31,
 
   
2011
   
2010
 
   
(Dollar amounts in thousands)
 
Balance at beginning of period
  $ 4,436     $ 3,468  
Charge-offs
    (875 )     (891 )
Recoveries:
    30       22  
Net charge-offs
    (845 )     (869 )
Provisions charged to operations
    825       1,425  
Balance at end of period
  $ 4,416     $ 4,024  
                 
Ratio of net charge-offs during the period to
average loans outstanding during the period
    1.14 %     1.04 %
                 
Allowance as a percentage of non-
performing loans
    72.2 %     30.1 %
                 
Allowance as a percentage of total
loans (end of period)
    1.49 %     1.35 %

During the quarter ended March 31, 2011, specific loan loss reserves decreased $350,000, while general loan loss reserves have increased $742,000.  Net charge-offs for the 2011 quarter were $845,000, or 1.1% of average loans on an annualized basis, compared to $869,000, or 1.0% of average loans for 2010 quarter.  The decrease was primarily due to decreased charge-offs on one-to-four family mortgages and home equity loans, and consumer loans.
 
As of March 31, 2011, the allowance for loan losses as a percentage of loans receivable and non-performing loans was 1.49% and 72.2%, respectively, compared to 1.35% and 30.1%, respectively, at March 31, 2010.  Allowance for loan losses as a percentage of loans receivable increased during the 2011 quarter due to the $825,000 of provision expense and a decline in number of loans specifically reserved for and decline in overall loans receivable.    Allowance for loan losses as a percentage of non-performing loans increased during the 2011 quarter due to a decrease in non-performing loans of $1.2 million and a $392,000 increase in the allowance.
 
Deposits.  Total deposits decreased by $4.8 million, or 1.7%, to $273.7 million at March 31, 2011, from $278.5 million at December 31, 2010.  During the first quarter of 2011, we experienced a $3.9 million decrease in interest-bearing demand accounts and a $883,000 decrease in noninterest-bearing demand accounts.
 
A summary of deposit accounts with the corresponding weighted average cost of funds is presented below (in thousands).

   
As of March 31, 2011
   
As of December 31, 2010
 
   
Amount
   
Wtd. Avg.
Rate
   
Amount
   
Wtd. Avg.
Rate
 
   
(Dollar amounts in thousands)
 
Checking (noninterest)
  $ 22,132       0.00 %   $ 22,148       0.00 %
NOW (interest)
    22,567       0.10 %     22,186       0.14 %
Savings
    21,829       0.10 %     21,598       0.18 %
Money Market
    80,911       0.53 %     77,257       0.69 %
Escrow
    4,055       0.00 %     4,922       0.00 %
Certificates
    122,239       1.69 %     130,383       2.30 %
Total
  $ 273,733       0.94 %   $ 278,494       1.29 %

 
28
 
 

Borrowings.  Federal Home Loan Bank advances decreased $2.9 million, or 11.5%, to $22.0 million at March 31, 2011, with a weighted-average yield of  1.94% from $24.8 million at December 31, 2010, with a weighted-average yield of 2.52%.  We continue to rely on Federal Home Loan Bank advances to fund interest earning asset growth when deposit growth is insufficient to fund such growth.  This reliance on borrowings, rather than deposits, may increase our overall cost of funds.  We decreased reliance on these borrowings during the first quarter of 2011, because even with our decreases in total deposits during the quarter, we had adequate funds to meet our cash needs for loan originations and expenses.
 
Equity.  Total equity increased $772,000, or 2.9%, to $27.7 million at March 31, 2011, from $26.9 million at December 31, 2010.  This reflects $496,000 in net income for the first quarter, net of tax, as decreases in accumulated other comprehensive losses of $242,000 and an increase in paid in capital of $33,000.
 
Comparison of Results of Operation for the Year Ended March 31, 2011 and 2010
 
General. Net income increased $439,000 to $496,000 for the quarter ended March 31, 2011, compared to net income of $57,000 for the quarter ended March 31, 2010.  The primary reason for this improvement was significant decreases in interest expense, the provision for loan losses and non-interest expense, which was partially offset by decreases in interest and non-interest income.
 
Interest Income.  Interest income decreased by $122,000, or 2.6%, to $4.6 million for the quarter ended March 31, 2011, from $4.8 million for the quarter ended March 31, 2010.  This decrease in interest income for the period reflects the decreased amount of average loans outstanding during the 2011 period and reduced investment balances and related interest income.
 
The weighted average yield on loans decreased from 6.3% for the quarter ended March 31, 2010, to 6.2% for the quarter ended March 31, 2011.  The decrease was primarily the result of the continued historically low rate environment throughout the year and competitive pricing pressures on loans to well-qualified borrowers.  The decrease in the weighted average yield on loans, however, was tempered by the increase in commercial loans, which typically have higher yields, as a percentage of the entire loan portfolio.  The weighted average yield on investments was 6.4% for the quarter ended March 31, 2011 compared to 5.5% for the same period during 2010, reflecting lower average balances of agency mortgage-backed securities, which produced a lower yield than the non-agency mortgage-backed securities that remained in our portfolio throughout the year.
 
Interest Expense.  Interest expense decreased $416,000, or 35.6%, to $752,000 for the quarter ended March 31, 2011, from $1.2 million for the quarter ended March 31, 2010.  This decrease reflects continuing lower interest rates paid on deposits and Federal Home Loan Bank advances and decreases in the average balances of deposits and borrowings during the 2011 period.  Our weighted average cost of interest-bearing liabilities was 1.0% for the quarter ended March 31, 2011, compared to 1.6% for the same period in 2010.
 
Interest paid on deposits decreased $372,000, or 36.5% to $648,000 for the quarter ended March 31, 2011, from $1.0 million for the quarter ended March 31, 2010.  This decrease resulted from a decrease in the weighted average cost of deposits and the $8.3 million decrease in the average balance of deposits outstanding during the 2011 period.  We experienced a 50 basis point decrease in the average rate paid on deposits during the quarter ended March 31, 2011 compared to the same period in 2010.  This decrease in average rates was a result of the repricing of matured certificate deposits that the Bank was able to retain at significantly lower rates as well as lower interest rates paid on existing savings, interest bearing checking and money market accounts and an emphasis by the Bank on attracting lower-cost product types such as savings, checking and money market accounts versus certificates of deposit.
 
Interest expense on borrowings decreased $44,000, or 29.7%, to $104,000 for the quarter ended March 31, 2011 from $148,000 for the quarter ended March 31, 2010.  The decrease resulted from a decrease of 73 basis points in our cost of borrowings from 2.67% in the 2010 period to 1.94% in the 2011 period and a $827,000, or 3.7% decrease in our average balance of outstanding borrowings at the Federal Home Loan Bank.
 

 
 
29
 
 

 
Net Interest Income.  Net interest income increased $294,000, or 8.2% to $3.9 million for the quarter ended March 31, 2011, from $3.6 million for the quarter ended March 31, 2010.  The increase in net interest income for the 2011 period primarily resulted from the lower rates on lower average balances of deposits and borrowings.  Our net interest margin was 5.18% for the quarter ended March 31, 2011, compared to 4.13% for the quarter ended March 31, 2010.
 
Provision for Loan Losses.  We establish provisions for loan losses, which are charged to earnings, at a level required to reflect management’s best estimate of the probable incurred credit losses in the loan portfolio.  In evaluating the level of the allowance for loan losses, management considers historical loss experience, the types of loans and the amount of loans in the loan portfolio, adverse situations that may affect borrowers’ ability to repay, estimated value of any underlying collateral, peer group data, prevailing economic conditions, and current factors.  Large groups of smaller balance homogeneous loans, such as residential real estate, small commercial real estate, home equity and consumer loans, are evaluated in the aggregate using historical loss factors adjusted for current economic conditions and other relevant data.  Loans for which management has concerns about the borrowers’ ability to repay, are evaluated individually, and specific loss allocations are provided for these loans when necessary.
 
A provision of $825,000 was made during the quarter ended March 31, 2011, compared to provision of $1.4 million during the quarter ended March 31, 2010.  The lower provision was primarily attributable to the improving performance of our loan portfolio and some improvement in market conditions nationally and in our market area.  The Company believes that elevated levels of nonperforming assets and charge-offs will continue until the housing market, unemployment, and general economic market conditions begin to show an extended period of recovery.
 
At March 31, 2010, the annualized percentage of net charge-offs to average loans increased 10 basis points to 1.14% from 1.04% at March 31, 2010.  The ratio of non-performing loans to total loans decreased from 4.50% at March 31, 2010 to 2.06% at March 31, 2011.  See “- Comparison of Financial Condition at March 31, 2011 and March 31, 2010 -- Delinquencies and Non-Performing Assets” for more information on non-performing loans during the first quarter of 2011.
 
Noninterest Income.  Noninterest income decreased $505,000, or 42.7%, to $679,000 during the first quarter of 2011, compared to $1.2 million during the quarter ended 2010 as reflected below:
 
   
Quarter Ended
March 31,
   
Amount
   
Percent
 
   
2011
   
2010
   
Change
   
Change
 
   
(Dollar amounts in thousands)
 
Service charges fee income
  $ 522     $ 528     $ (6 )     -1.1 %
Earnings on cash surrender value of bank owned
life insurance
    62       66       (4 )     -6.1 %
Mortgage servicing income
    135       165       (30 )     -18.2 %
Fair value adjustment  on mortgage servicing rights
    (1 )     285       (286 )     -100.4 %
Gain (loss) on sale of securities
    (34 )     75       (109 )     -145.3 %
Other-than-temporary impairment losses
    (39 )     ---       (39 )     n/a  
Gain on sale of loans
    34       64       (30 )     -46.9 %

Mortgage servicing income decreased as the result of an acceleration of the amortization of acquired and capitalized mortgage servicing rights due to a higher than anticipated level of loan payoffs during the year.  The fair value adjustment on mortgage servicing rights was also impacted by the low rate environment, which led to faster prepayment speeds, which directly impacted the market value.  Other-than-temporary impairment losses were higher in the 2011 quarter as the result of an other-than-temporary impairment one non-agency mortgage backed security during the period.  The reduction in the gain on sale of loans is a result of changes in the interest rate environment for residential mortgages as well as lower consumer demand, particularly for refinancing.  The loss on sale of securities was the result of the sale of two non-agency securities that were sold during the quarter.
 

 
30
 
 

Noninterest Expense.  As management increased efforts to control expenses in 2010, non-interest expense decreased $278,000, or 8.4%, to $3.0 million during the quarter ended March 31, 2011, compared to $3.3 million during 2010, as reflected below:
 
   
Quarter Ended March 31,
   
Amount
   
Percent
 
   
2011
   
2010
   
Change
   
Change
 
Salaries and benefits
  $ 1,466     $ 1,617     $ (151 )     -9.3 %
Operations
    668       834       (166 )     -19.9 %
Regulatory assessments
    225       231       (6 )     -2.6 %
Occupancy
    294       381       (87 )     -22.8 %
Data processing
    239       200       39       19.5 %
Net loss on sale of OREO and repossessed assets
    139       48       91       189.6 %

Salaries and benefits decreased in the 2011 period as a result of the reduction in force implemented in 2010, which reduced the number of employees at the beginning of 2011 by 17 from the level at the beginning of 2010.  Operations and occupancy expense decreased during the 2011 period as the result the closing of our East Marginal Way branch in South Seattle and of lower collection expense in the 2011 quarter compared to the 2010 quarter due to a lower volume of new delinquencies and management efforts to reduce expenses in this area.  In addition, the Company had lower legal, professional and marketing expense during the 2011 period.  Data processing expenses were higher in the 2011 period due to several technology initiatives launched in 2011 to enhance our offerings in online and mobile banking.  We experienced an increase in net losses on the sale of repossessed assets as a result of continuing market value declines and more aggressive pricing of our repossessed assets in order to meet market expectations.
 
Income Tax Expense.   For the quarter ended March 31, 2011, we had an income tax expense of $222,000 on our pre-tax income of $718,000 as compared to income tax benefit of $7,000 on pre-tax income of $50,000 for the quarter ended March 31, 2010.  The effective tax rates for March 31, 2011 and March 31, 2010 were 31.0% and -14.2%, respectively.
 
Liquidity
 
The Management Discussion and Analysis in Item 7 of the Company’s Form 10-K Annual Report filed with the SEC on March 31, 2011 contains an overview of the Company’s and the Bank’s liquidity management, sources of liquidity and cash flows.  This discussion updates that disclosure for the first quarter of 2011.
 
At March 31, 2011, the Bank had $9.4 million in cash and investment securities available for sale and $79,000 in loans held for sale generally available for its cash needs.  It also had the ability to borrow an additional $92.4 million in Federal Home Loan Bank advances, $24.8 million through the Federal Reserve’s Discount Window and $2.0 million through Pacific Coast Banker’s Bank.  The Bank uses these sources of funds primarily to meet ongoing commitments, pay maturing deposits and fund withdrawals, and to fund loan commitments.  At March 31, 2011, the approved outstanding loan commitments, including unused lines and letters of credit, amounted to $33.2 million.  Certificates of deposit scheduled to mature in one year or less at March 31, 2011, totaled $60.9 million, and based on our competitive pricing, we believe that a majority of maturing deposits will remain with the Bank.
 
As a separate legal entity from the Bank, the Company must provide for its own liquidity.  At March 31, 2011, the Company, on an unconsolidated basis, had $518,000 in cash, interest-bearing deposits and liquid investments generally available for its cash needs.
 
Except as set forth above, management is not aware of any trends, events, or uncertainties that will have, or that are reasonably likely to have a material impact on liquidity, capital resources or operations.  Further, management is not aware of any current recommendations by regulatory agencies which, if they were to be implemented, would have this effect.
 

 
31
 
 


Off-Balance Sheet Activities
 
In the normal course of operations, the Company engages in a variety of financial transactions that are not recorded in our financial statements.  These transactions involve varying degrees of off-balance sheet credit, interest rate and liquidity risks.  These transactions are used primarily to manage customers’ requests for funding and take the form of loan commitments and lines of credit.  During the quarter ended March 31, 2011, we engaged in no off-balance sheet transactions likely to have a material effect on our financial condition, results of operations or cash flows.
 
A summary of our off-balance sheet loan commitments at March 31, 2011, is as follows (in thousands):
 
Off-balance sheet loan commitments
 
(in thousands)
 
Commitments to extend credit
  $ 1,557  
Undisbursed nonrevolving lines of credit
    3,960  
Undisbursed revolving lines of credit
    27,430  
Irrevocable letters of credit
    275  
Total loan commitments
  $ 33,222  
 
Capital
 
The Bank is subject to minimum capital requirements imposed by regulations of the OTS.  Based on its capital levels at March 31, 2011, the Bank exceeded these requirements as of that date and continues to exceed them as of the date of this Form 10-K Annual Report.  Consistent with our goals to operate a sound and profitable organization, our policy is for the Bank to maintain a “well-capitalized” status under the regulatory capital categories of the OTS.  Based on capital levels at March 31, 2011, the Bank was considered to be well-capitalized.  The Bank has agreed in its MOU to reach as of March 31, 2011, and retain thereafter, 8% core capital and 12% total risk-based capital, which levels are greater than that required by OTS regulations or necessary for well-capitalized status.  As noted below, the Bank met these higher capital requirements as of March 31, 2011.  Management monitors the capital levels of the Bank to provide for current and future business opportunities, maintain “well-capitalized” status and maintain the required levels in the MOU.
 
The following table shows the capital ratios of the Bank at March 31, 2011.
 
 
Actual
 
Minimum Capital
Requirements
 
Minimum Required to
Be Well-Capitalized
Under Prompt
Corrective
Action Provisions
 
Minimum Required
Under MOU by
March 31, 2011
 
Amount
  
Ratio
  
Amount
  
Ratio
  
Amount
 
Ratio
 
Amount
 
Ratio
 
(Dollar amounts in thousands)
Tier 1 Capital to total adjusted assets(1)
$26,952
 
    8.25%
 
$13,073
4.0%
 
$16,341
  5.0%
 
$26,146
  8.0%
Tier 1 Capital to risk-weighted assets(2)
$26,952
 
  10.87%
 
$  9,915
    4.0%
(3)
$14,873
  6.0%
 
N/A
 
    N/A
Total Capital to risk-weighted assets(2)
$30,050
 
  12.12%
 
$19,830
8.0%
 
$24,788
10.0%
 
$29,745
12.0%
________________________
(1)
Based on total adjusted assets of $326.8 million.
(2)
Based on risk-weighted assets of $247.9 million.
(3)
The Tier 1 risk-based capital requirement for a well-capitalized institution is 6% of risk-weighted assets.

 
32
 
 


Forward-Looking Statements
 
When used in this Form 10-Q, future filings with the SEC, Company press releases or other public or stockholder communications and oral statements made with the approval of an authorized executive officer, the words or phrases “will likely result,” “are expected to,” “will continue,” “is anticipated,” “estimate,” “project,” “intends” or similar expressions are intended to identify “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995.  Such statements are subject to certain risks and uncertainties, including, among other things, (i) changes in economic conditions, either nationally or in the Company’s market areas; (ii) fluctuations in interest rates; (iii) the risks of lending and investing activities, including changes in the level and direction of loan delinquencies and write-offs and changes in estimates of the adequacy of the allowance for loan losses; (iv) the possibility of other-than-temporary impairments of securities held in the Company’s securities portfolio; (v) the Company’s ability to access cost-effective funding; (vi) fluctuations in real estate values and both residential and commercial real estate market conditions; (vii) demand for loans and deposits in the Company’s market areas; (viii) expected cost savings, synergies and other benefits from the Company’s merger and acquisition activities might not be realized within the anticipated time frames or at all, and costs or difficulties relating to integration matters, including but not limited to customer and employee retention, might be greater than expected; (ix) legislative or regulatory changes that adversely affect the Company’s business; (x) monetary and fiscal policies of the Federal Reserve Board and the U.S. Government and other governmental initiatives affecting the financial services industry; (xi) results of examinations of the Company and the Bank by their regulators, including the possibility that the regulators may, among other things, require the Company to increase its allowance for loan losses or to write-down assets; (xii) costs and effects of litigation, including settlements and judgments; and (xiii) competition.  The Company wishes to advise readers that the factors listed above could affect the Company’s financial performance and could cause the Company’s actual results for future periods to differ materially from any opinions or statements expressed with respect to future periods in any current statements.
 
The Company does not undertake and specifically declines any obligation to publicly release the result of any revisions which may be made to any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence or unanticipated events.
 
 Item 3.  Quantitative and Qualitative Disclosures About Market Risk
 
The Company is a smaller reporting company and is not required to provide this disclosure.
 
The Company provided information about market risk in Item 7A of its Form 10-K Annual Report filed with the SEC on March 31, 2011.  There have been no material changes in our market risk since our December 31, 2010 year end.
 
Item 4    Controls and Procedures

(a)  
Evaluation of Disclosure Controls and Procedures.

An evaluation of the Company's disclosure controls and procedures as defined in Rule 13a -15(e) under the Securities Exchange Act of 1934 (the "Act") as of March 31, 2011, was carried out under the supervision and with the participation of the Company's Chief Executive Officer, Chief Financial Officer and several other members of the Company's senior management. The Chief Executive Officer and Chief Financial Officer concluded that, as of March 31, 2011, the Company's disclosure controls and procedures were effective in ensuring that the information required to be disclosed by the Company in the reports it files or submits under the Act is: (i) accumulated and communicated to the Company's management (including the Chief Executive Officer and the Chief Financial Officer) in a timely manner, and (ii) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.
 
 
 
33
 
 
 
 
 
We intend to continually review and evaluate the design and effectiveness of the Company’s disclosure controls and procedures and to improve the Company’s controls and procedures over time and to correct any deficiencies that we may discover in the future. The goal is to ensure that senior management has timely access to all material financial and non-financial information concerning the Company's business. While we believe the present design of the disclosure controls and procedures is effective to achieve this goal, future events affecting our business may cause the Company to modify its disclosure controls and procedures.
 
The Company does not expect that its disclosure controls and procedures will prevent all error and all fraud. A control procedure, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control procedure are met. Because of the inherent limitations in all control procedures, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. 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 control procedure is also 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, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies and procedures may deteriorate. Because of the inherent limitations in a cost-effective control procedure, misstatements due to error or fraud may occur and not be detected.
 
(b)  
Changes in Internal Controls over Financial Reporting.
 
There were no changes in our internal control over financial reporting (as defined in Rule 13a - 15(f) under the Act) that occurred during the quarter ended March 31, 2011, that has materially affected, or is likely to materially affect our internal control over financial reporting.
 

 
34
 
 


 
PART II                      OTHER INFORMATION
 
Item 1          Legal Proceedings

In the normal course of business, the Company occasionally becomes involved in various legal proceedings.  In the opinion of management, any liability from such proceedings would not have a material adverse effect on the business or financial condition of the Company.

Item 1A       Risk Factors

Not required; the Company is a smaller reporting company.
 
Item 2          Unregistered Sales of Equity Securities and use of Proceeds

Nothing to report.

Item 3          Defaults Upon Senior Securities

Nothing to report.

Item 4          Reserved

Nothing to report.

Item 5.         Other Information

Nothing to report.
 
 
 
 
 

 
35
 
 

Item 6                      Exhibits
Exhibit Number
Document
Reference to
Prior Filing
or Exhibit Number
Attached Hereto
     
3.1
Charter for Sound Financial, Inc.
*
3.2
Bylaws of Sound Financial, Inc.
**
4
Form of Stock Certificate of Sound Financial, Inc.
**
10.1
Employment Agreement with Laura Lee Stewart
*
10.2
Executive Long Term Compensation Agreement with Laura Lee Stewart
*
10.3
Executive Long Term Compensation Agreement with Patricia Floyd
*
10.4
Sound Community Incentive Compensation Achievement Plan
*
10.5
Summary of Annual Bonus Plan
*
10.6
Summary of Quarterly Bonus Plan
*
10.7
Director Fee Arrangements for 2009
***
10.8
Sound Financial, Inc. 2008 Equity Incentive Plan
***
10.9
Form of Incentive Stock Option Agreement under the 2008 Equity Incentive Plan
+
10.10
Form of Non-Qualified Stock Option Agreement under the 2008 Equity Incentive Plan
+
10.11
Form of Restricted Stock Agreement under the 2008 Equity Incentive Plan
+
10.12
Employment Agreements with executive officers Matthew Denies,
Matthew Moran, Scott Boyer and Marlene Price
++
11
Statement re computation of per share earnings
None
15
Letter re unaudited interim financial information
None
18.1
Letter re change in accounting principles
+++
19
Reports furnished to security holders
None
22
Published report regarding matters submitted to vote of security holders
None
23
Consents
None
24
Power of Attorney
None
31.1
Rule 13a–14(a) Certification of Chief Executive Officer
31.1
31.2
Rule 13a–14(a) Certification of Chief Financial Officer
31.2
32
Section 1350 Certification
32
*
Filed as an exhibit to the Company's Form SB–2 registration statement filed on September 20, 2007 (File No.333–146196) pursuant to Section 5 of the Securities Act of 1933.
**
Filed as an exhibit to Pre-effective Amendment No. 1 to the Company's Form SB–2 registration statement filed on November 2, 2007 (File No.333–146196) pursuant to Section 5 of the Securities Act of 1933.
***
Filed as an exhibit to the Company’s Form 10-K filed on March 31, 2009.
+
Filed as an exhibit to the Company’s Form 8-K filed on January 29. 2009.
++
Filed as an exhibit to the Company’s Form 8-K filed on November 5, 2009.
+++
Filed as an exhibit to the Company’s Form 10-Q filed on May 17, 2010.


 
36
 
 


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.




   
SOUND FINANICAL, INC.
     
     
     
May 16, 2011
By:
/s/  Laura Lee Stewart
   
Laura Lee Stewart
   
President and Chief Executive Officer
     
     
     
     
May 16, 2011
By:
/s/  Matthew P. Deines
   
Matthew P. Deines
   
Executive Vice President
   
Chief Financial Officer
   
Principal Financial and Accounting Officer




 
37
 
 

Exhibit Index


31.1
Rule 13a–14(a) Certification of Chief Executive Officer
31.1
31.2
Rule 13a–14(a) Certification of Chief Financial Officer, Principal Financial and Accounting Principal
31.2
32
Section 1350 Certification
32