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EX-32 - EXHIBIT 32 - Sound Financial, Inc.ex32.htm
EX-31.1 - EXHIBIT 31.1 - Sound Financial, Inc.ex31-1.htm
EX-31.2 - EXHIBIT 31.2 - Sound Financial, Inc.ex31-2.htm
 
 

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q/A

(Mark One)

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

For the quarterly period ended March 31, 2012

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 [X]   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                Accelerated filer                Non-accelerated filer                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 11, 2012, there were 2,960,045 shares of the registrant’s common stock outstanding.
 
 
 
 

 
 
EXPLANATORY NOTE
 
This amendement (Form 10-Q/A) is being provided for the sole purpose of furnishing Exhibits 31.1 - Rule 13a-14(a) Certification of Chief Executive Officer, 31.2 - Rule 13a-14(a) - Certification of Chief Financial Officer, Principal Financial and Accounting Principal and 32 - Section 1350 Certification, which should have been filed with our Form 10-Q for the period ended March 31, 2012 as filed on May 15, 2012.  As a result of a technical error, the Exhibits 31.1, 31.2 and 32 were inadvertantly omitted from the Form 10-Q.
 
No other changes have been made to the Form 10-Q.  This Form 10-Q/A does not reflect events that may have occurred subsequent to the original filing date and does not modify or update any related disclosures made in the Form 10-Q.
 
 

 
 
 

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended March 31, 2012

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 [X]   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                Accelerated filer                Non-accelerated filer                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 11, 2012, there were 2,960,045 shares of the registrant’s common stock outstanding.


 
 

 

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

 
Page Number
PART I                 FINANCIAL INFORMATION
 
 
Item 1.           Financial Statements
 
 
     Condensed Consolidated Balance Sheets as of March 31, 2012 (unaudited) and December 31, 2011
 
3
     Condensed Consolidated Statements of Income for the Three Month Periods Ended March 31, 2012 and 2011 (unaudited)`
 
4
Condensed Consolidated Statements of Comprehensive Income for the Three Month Periods Ended March 31, 2012 and 2011 (unaudited)
 
5
     Condensed Consolidated Statement of Stockholders’ Equity for the Three Month Period Ended March 31, 2012 (unaudited)
 
6
    Condensed Consolidated Statements of Cash Flows for the Three Month Periods Ended March 31, 2012 and 2011 (unaudited)
 
7
     Selected Notes to Condensed Consolidated Financial Statements
 
8
Item 2.    Management's Discussion and Analysis of Financial Condition and Results of Operations
 
34
Item 3.    Quantitative and Qualitative Disclosures About Market Risk
 
42
Item 4.    Controls and Procedures
 
42
PART II                 OTHER INFORMATION
 
44
Item 1.             Legal Proceedings
 
44
Item 1A          Risk Factors
 
44
Item 2.    Unregistered Sales of Equity Securities and Use of Proceeds
 
44
Item 3.    Defaults Upon Senior Securities
 
44
Item 4.    Mine Safety Disclosures
 
44
Item 5.    Other Information
 
44
Item 6.    Exhibits
 
45
SIGNATURES
 
 
EXHIBITS
 


 
2

 


PART I                      FINANCIAL INFORMATION

Item 1                      Financial Statements

SOUND FINANCIAL, INC AND SUBSIDIARY
 
Condensed Consolidated Balance Sheets
 
(Unaudited)
 
   
MARCH 31,
   
DECEMBER 31,
 
   
2012
   
2011
 
   
(Dollars in thousands)
 
ASSETS
           
Cash and cash equivalents
  $ 25,409     $ 17,031  
Available-for-sale securities, at fair value
    3,035       2,992  
Federal Home Loan Bank stock, at cost
    2,444       2,444  
Loans held for sale
    1,139       1,807  
Loans
    300,743       300,096  
Less allowance for loan losses
    (4,350 )     (4,455 )
Total loans, net
    296,393       295,641  
                 
Accrued interest receivable
    1,153       1,234  
Premises and equipment, net
    2,310       2,385  
Bank-owned life insurance, net
    7,047       6,981  
Mortgage servicing rights, at fair value
    2,791       2,437  
Other real estate owned and repossessed assets, net
    2,065       2,821  
Other assets
    4,911       3,967  
Total assets
  $ 348,697     $ 339,740  
                 
LIABILITIES
               
Deposits
               
Interest-bearing
    275,523       269,421  
Noninterest-bearing demand
    32,253       30,576  
Total deposits
    307,776       299,997  
                 
Borrowings
    8,346       8,506  
Accrued interest payable
    82       84  
Other liabilities
    2,448       2,149  
Advance payments from borrowers for taxes and insurance
    579       291  
Total liabilities
    319,231       311,027  
                 
COMMITMENTS AND CONTINGENCIES (NOTE 6)
               
                 
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, 2,960,045 issued and outstanding as of March 31, 2012 and December 31, 2011
    30       30  
Additional paid-in capital
    11,973       11,939  
Unearned shares - Employee Stock Ownership Plan (“ESOP”)
    (693 )     (693 )
Retained earnings
    18,641       18,096  
Accumulated other comprehensive loss, net of tax
    (485 )     (659 )
Total stockholders’ equity
    29,466       28,713  
Total liabilities and stockholders’ equity
  $ 348,697     $ 339,740  

See notes to condensed consolidated financial statements

 
3

 

                                                                                                                                                                                                                    SOUND FINANCIAL, INC. AND SUBSIDIARY
Condensed Consolidated Statements of Income
 (Unaudited)
       
   
THREE MONTHS ENDED
 
   
MARCH 31,
 
   
2012
   
2011
 
   
(Dollars in thousands, except per share amounts)
 
INTEREST INCOME
           
Loans, including fees
  $ 4,508     $ 4,586  
Interest and dividends on investments, cash and cash equivalents
    55       62  
Total interest income
    4,563       4,648  
                 
INTEREST EXPENSE
               
Deposits
    546       648  
Borrowings
    55       104  
Total interest expense
    601       752  
                 
NET INTEREST INCOME
    3,962       3,896  
                 
PROVISION FOR LOAN LOSSES
    1,500       825  
                 
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES
    2,462       3,071  
                 
NONINTEREST INCOME
               
Service charges and fee income
    550       522  
Earnings on cash surrender value of bank-owned life insurance
    66       62  
Mortgage servicing income
    177       135  
Fair value adjustment on mortgage servicing rights
    384       (1 )
Loss on sale of securities
    -       (34 )
Other-than-temporary impairment losses on securities
    (91 )     (39 )
Gain on sale of loans
    251       34  
Total noninterest income
    1,337       679  
                 
NONINTEREST EXPENSE
               
Salaries and benefits
    1,283       1,466  
Operations
    582       669  
Regulatory assessments
    122       225  
Occupancy
    310       294  
Data processing
    242       239  
Losses and expenses on other real estate owned and repossessed assets
    469       139  
Total noninterest expense
    3,008       3,032  
                 
INCOME BEFORE PROVISION FOR INCOME TAXES
    791       718  
                 
PROVISION FOR INCOME TAXES
    245       222  
                 
NET INCOME
  $ 546     $ 496  
                 
BASIC EARNINGS PER SHARE
  $ 0.19     $ 0.17  
DILUTED EARNINGS PER SHARE
  $ 0.19     $ 0.17  

See notes to condensed consolidated financial statements

 
4

 


                                                                                                                                                                                                               SOUND FINANCIAL, INC. AND SUBSIDIARY
Condensed Consolidated Statements of Comprehensive Income
(Unaudited)


   
THREE MONTHS ENDED
 
   
MARCH 31,
 
   
2012
   
2011
 
   
(Dollars in thousands)
 
Net income
  $ 546     $ 496  
Other comprehensive income, net of tax
               
Unrealized holding gain, net of
               
taxes of $90 and $125 respectively
    174       242  
Reclassification adjustments for losses on
               
sales of securities, net of taxes of $0 and $12, respectively
    -       22  
Reclassification adjustments for other-than-temporary
               
impairment on securities, net of taxes of $31 and $13, respectively
    60       26  
                 
Other comprehensive income
    234       290  
                 
Comprehensive income
  $ 780     $ 786  
                 

    See notes to condensed consolidated financial statements

 
5

 

SOUND FINANCIAL, INC. AND SUBSIDIARY
Condensed Consolidated Statement of Stockholders’ Equity
For the Three Months Ended March 31, 2012
(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, 2011
    2,949     $ 30     $ 11,939     $ (693 )   $ 18,096     $ (659 )   $ 28,713  
                                                         
Net income
                                    546               546  
                                                         
Net unrealized gain in fair value of available for sale securities, net of tax of $90
            -       -       -       -       174       174  
                                                         
Restricted stock awards
    11       -       -                               -  
                                                         
Share-based compensation
                    33                               33  
                                                         
BALANCE, March 31, 2012
    2,960     $ 30     $ 11,972     $ (693 )   $ 18,642     $ (485 )   $ 29,466  
                                                         

See notes to condensed consolidated financial statements

 
6

 

SOUND FINANCIAL, INC. AND SUBSIDIARY
Condensed Consolidated Statements of Cash Flows
(unaudited)
 
 
   
THREE MONTHS ENDED MARCH 31,
 
   
2012
   
2011
 
CASH FLOWS FROM OPERATING ACTIVITIES
 
(Dollars in thousands)
 
Net income
  $ 546     $ 496  
Adjustments to reconcile net income to net cash from operating activities
               
Loss on sale of available for sale securities
    -       34  
Other-than-temporary impairment losses on securities
    91       39  
Provision for loan losses
    1,500       825  
Depreciation and amortization
    90       99  
Compensation expense related to stock options and restricted stock
    33       33  
Fair value adjustment on mortgage servicing rights
    (384 )     1  
Additions to mortgage servicing rights
    (185 )     (148 )
Amortization of mortgage servicing rights
    215       201  
Increase in cash surrender value of bank owned life insurance
    (66 )     (62 )
Proceeds from sale of loans
    21,132       14,869  
Originations of loans held for sale
    (20,213 )     (14,012 )
Loss on sale of other real estate owned and repossessed assets
    255       45  
Gain on sale of loans
    (251 )     (34 )
(Decrease) increase in operating assets and liabilities
               
Accrued interest receivable
    81       34  
Other assets
    (1,034 )     928  
Accrued interest payable
    (2 )     (26 )
Other liabilities
    299       (922 )
                 
Net cash provided by operating activities
    2,107       2,400  
                 
CASH FLOWS FROM INVESTING ACTIVITIES
               
Proceeds from principal payments, maturities and sales of available for sale securities
    130       1,187  
Net increase in loans
    (2,735 )     (3 )
Improvements to OREO and other repossessed assets
    (206 )     (30 )
Proceeds from sale of OREO and other repossessed assets
    1,190       566  
Purchases of premises and equipment
    (15 )     (13 )
                 
Net cash provided (used) by investing activities
    (1,636 )     1,707  
                 
CASH FLOWS FROM FINANCING ACTIVITIES
               
Net increase (decrease) in deposits
    7,779       (4,761 )
Proceeds from borrowings
    -       28,000  
Repayment of borrowings
    (160 )     (30,861 )
Net change in advances from borrowers for taxes and insurance
    288       157  
                 
Net cash provided (used) by financing activities
    7,907       (7,465 )
                 
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
    8,378       (3,358 )
                 
CASH AND CASH EQUIVALENTS, beginning of period
    17,031       9,092  
                 
CASH AND CASH EQUIVALENTS, end of period
  $ 25,409     $ 5,734  

SUPPLEMENTAL CASH FLOW INFORMATION
           
Cash paid for income taxes
  $ -     $ 220  
Interest paid on deposits and borrowings
  $ 603     $ 778  
Net transfer of loans to other real estate owned
  $ 483     $ 1,069  
 
See notes to condensed consolidated financial statements

 
7

 


SOUND FINANCIAL, INC. AND SUBSIDIARY
Selected 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.  These unaudited financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2011, as filed with the SEC.  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, 2011, 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 April 2011, the FASB issued ASU No. 2011-03, Reconsideration of Effective Control for Repurchase Agreements.  The Update amends existing guidance to remove from the assessment of effective control, the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee and, as well, the collateral maintenance implementation guidance related to that criterion.  ASU No. 2011-03 is effective for the Company’s reporting period beginning on or after December 15, 2011.  The guidance applies prospectively to transactions or modification of existing transactions that occur on or after the effective date and early adoption is not permitted.  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. 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.  The Update amends existing guidance regarding the highest and best use and valuation premise by clarifying these concepts are only applicable to measuring the fair value of nonfinancial assets.  The Update also clarifies that the fair value measurement of financial assets and financial liabilities which have offsetting market risks or counterparty credit risks that are managed on a portfolio basis, when several criteria are met, can be measured at the net risk position.  Additional disclosures about Level 3 fair value measurements are required including a quantitative disclosure of the unobservable inputs and assumptions used in the measurement, a description of the valuation process in place, and discussion of the sensitivity of fair value changes in unobservable inputs and interrelationships about those inputs as well disclosure of the level of the fair value of items that are not measured at fair value in the financial statements but disclosure of fair value is required. The provisions of ASU No. 2011-04 are effective for the Company’s reporting period beginning after December 15, 2011 and are applied prospectively.  The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.

 
8

 


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

 
In June 2011, the FASB issued ASU No. 2011-05, Presentation of Comprehensive Income.  The Update amends current guidance to allow a company the option of presenting the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements.  The provisions do not change the items that must be reported in other comprehensive income or when an item of other comprehensive must to reclassified to net income.  The amendments do not change the option for a company to present components of other comprehensive income either net of related tax effects or before related tax effects, with one amount shown for the aggregate income tax expense (benefit) related to the total of other comprehensive income items.  The amendments do not affect how earnings per share is calculated or presented.  The provisions of ASU No. 2011-05 are effective for the Company’s reporting period beginning after December 15, 2011 and are applied retrospectively.  Early adoption was permitted and there are no required transition disclosures. In December 2011, the FASB issued ASU No. 2011-12, Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05.  The ASU defers indefinitely the requirement to present reclassification adjustments and the effect of those reclassification adjustments on the face of the financial statements where net income is presented, by component of net income, and on the face of the financial statements where other comprehensive income is presented, by component of other comprehensive income.  The adoption of the ASUs did not have a material impact on the Company’s consolidated financial statements.
 
In December 2011, the FASB issued ASU No. 2011-11, Disclosures about Offsetting Assets and Liabilities.  The update requires an entity to offset, and present as a single net amount, a recognized eligible asset and a recognized eligible liability when it has an unconditional and legally enforceable right of setoff and intends either to settle the asset and liability on a net basis or to realize the asset and settle the liability simultaneously.  The ASU requires an entity to disclose information about offsetting and related arrangements to enable users of its financial statements to understand the effect of those arrangements on its financial position.  The amendments are effective for annual and interim reporting periods beginning on or after January 1, 2013.  The Company is currently in the process of evaluating the ASU but does not expect it will have a material impact on the Company’s consolidated financial statements.

 
9

 


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

Note 3 – 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, 2012
 
(in thousands)
 
Agency mortgage-backed securities
  $ 52     $ 6     $ -     $ -     $ 58  
Non-agency mortgage-backed securities
    3,718       -       -       (741 )   $ 2,977  
     Total
  $ 3,770     $ 6     $ -     $ (741 )   $ 3,035  
                                         
   
           
Gross Unrealized
         
   
Amortized
Cost
   
Gains
   
Losses 1 Year
or Less
   
Losses Greater
Than 1 Year
   
Estimated Fair
Value
 
December 31, 2011
 
(in thousands)
 
Agency mortgage-backed securities
  $ 53     $ 6     $ -     $ -     $ 59  
Non-agency mortgage-backed securities
    3,939       -       -       (1,006 )     2,933  
     Total
  $ 3,992     $ 6     $ -     $ (1,006 )   $ 2,992  
                                         

The amortized cost and fair value of mortgage-backed securities by contractual maturity, at March 31, 2012, 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, 2012
 
   
Amortized Cost
   
Fair Value
 
   
(in thousands)
 
Due after ten years
  $ 3,770     $ 3,035  

Securities with a carrying value of $58,000 at March 31, 2012 were pledged to secure Washington State Public Funds.  Additionally, the Company has letters of credit with a notional amount of $29.0 million to secure public deposits.

 
10

 


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

Sales of available for sale securities were as follows:

   
Three Months Ended March 31,
 
   
2012
   
2011
 
   
(in thousands)
 
Proceeds
  $ -     $ 1,096  
Gross gains
    -       3  
Gross losses
    -       (37 )

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, 2012
 
   
Less Than 12 Months
   
12 Months or Longer
   
Total
 
   
Fair Value
   
Unrealized Loss
   
Fair Value
   
Unrealized Loss
   
Fair Value
   
Unrealized Loss
 
   
(in thousands)
 
Non-agency mortgage-backed securities
  $ -     $ -     $ 2,977     $ (741 )   $ 2,977     $ (741 )
Total
  $ -     $ -     $ 2,977     $ (741 )   $ 2,977     $ (741 )
                                                 
   
December 31, 2011
 
   
Less Than 12 Months
   
12 Months or Longer
   
Total
 
   
Fair Value
   
Unrealized Loss
   
Fair Value
   
Unrealized Loss
   
Fair Value
   
Unrealized Loss
 
   
(in thousands)
 
Non-agency mortgage-backed securities
  $ -     $ -     $ 2,933     $ (1,006 )   $ 2,933     $ (1,006 )
Total
  $ -     $ -     $ 2,933     $ (1,006 )   $ 2,933     $ (1,006 )


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,
 
   
2012
   
2011
 
   
(in thousands)
 
Estimated credit losses, beginning balance
  $ 256     $ 39  
Additions for credit losses not previously recognized
    91       -  
Reduction for increases in cash flows
    -       -  
Reduction for realized losses
    -       -  
Estimated losses, ending balance
  $ 347     $ 39  


 
11

 


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

As of March 31, 2012, our securities portfolio consisted of two U.S. agency and five non-U.S. agency mortgage backed securities with a fair value of $3.0 million, of which, all five 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.  The contractual terms of these investments do not permit the issuer to settle the securities at a price less than par.  While management does not intend to sell the non-agency mortgage backed securities, and it is unlikely 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 an other-than-temporary impairment (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 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, 2012, four securities reflected OTTI during the three month period ended March 31, 2012.  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 assist management with modeling cash flows.  The model includes each individual non-agency mortgage backed securities’ structural features.  The modeled cash flows are discounted 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 $91,000 in non-cash pre-tax impairment charges for the three months ended March 31, 2012.  Cumulative at March 31, 2012, the Company has recognized a total of $347,000 of OTTI on four of the five non-agency mortgage backed securities.


 
12

 


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

Note 5 – Loans

The composition of the loan portfolio, including loans held for sale, is as follows:

 
    March 31 2012     December 31, 2011  
         
   
(in thousands)
 
Real Estate Loans:
           
One-to four- family
  $ 98,600     $ 96,305  
Home equity
    38,654       39,656  
Commercial and multifamily
    105,313       106,016  
Construction and land
    18,226       17,805  
Total real estate loans
    260,793       259,782  
                 
Consumer loans:
               
Manufactured homes
    17,994       18,444  
Other consumer
    10,267       10,920  
Total consumer loans
    28,261       29,364  
                 
Commercial business loans
    13,291       13,163  
                 
Total loans
    302,345       302,309  
Deferred fees
    (463 )     (406 )
Loans held for sale
    (1,139 )     (1,807 )
Total loans, gross
    300,743       300,096  
Allowance for loan losses
    (4,350 )     (4,455 )
Total loans, net
  $ 296,393     $ 295,641  
 
13

 

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


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 March 31, 2012:

   
One- to four- family
   
Home equity
   
Commercial and multifamily
   
Construction and land
   
Manufactured homes
   
Other consumer
   
Commercial business
   
Unallocated
   
Total
 
   
(In thousands)
 
Allowance for loan losses:
                             
Ending balance: individually evaluated for impairment
  $ 869     $ 229     $ 62     $ 18     $ 170       7       115       -     $ 1,470  
Ending balance: collectively evaluated for impairment
    713       1,181       446       48       207       135       119       31       2,880  
Ending balance
  $ 1,582     $ 1,410     $ 508     $ 66     $ 377     $ 142     $ 234     $ 31     $ 4,350  
   
Loans receivable:
                                     
Ending balance: individually evaluated for impairment
  $ 9,507     $ 1,948     $ 2,259     $ 805     $ 904     $ 92     $ 971     $ -     $ 16,486  
Ending balance: collectively evaluated for impairment
    89,093       36,706       103,054       17,421       17,090       10,175       12,320       -     $ 285,859  
Ending balance
  $ 98,600     $ 38,654     $ 105,313     $ 18,226     $ 17,994     $ 10,267     $ 13,291     $ -     $ 302,345  
                                                                         

 
14

 


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

 

 
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, 2011:
 

 
   
One- to four- family
   
Home equity
   
Commercial and multifamily
   
Construction and land
   
Manufactured homes
   
Other consumer
   
Commercial business
   
Unallocated
   
Total
 
   
(In thousands)
 
Allowance for loan losses:
                             
Ending balance: individually evaluated for impairment
  $ 541     $ 447     $ 38     $ 37     $ 11     $ 48     $ 132     $ -     $ 1,254  
Ending balance: collectively evaluated for impairment
    576       979       931       68       279       165       122       81       3,201  
Ending balance
  $ 1,117     $ 1,426     $ 969     $ 105     $ 290     $ 213     $ 254     $ 81     $ 4,455  
   
Loans receivable:
                                     
Ending balance: individually evaluated for impairment
  $ 8,260     $ 1,784     $ 2,003     $ 902     $ 122     $ 101     $ 447     $ -     $ 13,619  
Ending balance: collectively evaluated for impairment
    88,045       37,872       104,013       16,903       18,322       10,819       12,716       -       288,690  
Ending balance
  $ 96,305     $ 39,656     $ 106,016     $ 17,805     $ 18,444     $ 10,920     $ 13,163     $ -     $ 302,309  
                                                                         

 
15

 

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

 
The following table summarizes the activity in loan losses for the three months ended March 31, 2012:
 
   
Beginning
Allowance
   
Charge-offs
   
Recoveries
   
Provision
   
Ending
Allowance
 
   
(in thousands)
 
One-to four- family
  $ 1,117     $ (750 )   $ -     $ 1,215     $ 1,582  
Home equity
    1,426       (714 )     2       697       1,410  
Commercial and multifamily
    969       -       -       (461 )     508  
Construction and land
    105       (37 )     -       (2 )     66  
Manufactured homes
    290       (28 )     1       114       377  
Other consumer
    213       (78 )     7       2       142  
Commercial business
    254       (6 )     -       (14 )     234  
Unallocated
    81       -       -       (50 )     31  
    $ 4,455     $ (1,613 )   $ 10     $ 1,500     $ 4,350  


The following table summarizes the activity in loan losses for the three months ended March 31, 2011:

   
Beginning
Allowance
   
Charge-offs
   
Recoveries
   
Provision
   
Ending
Allowance
 
   
(in thousands)
 
One-to four- family
  $ 909     $ (242 )   $ 10     $ 163     $ 840  
Home equity
    1,480       (432 )     5       327       1,380  
Commercial and multifamily
    664       (70 )     -       310       904  
Construction and land
    205       -       -       5       210  
Manufactured homes
    293       (101 )     1       42       235  
Other consumer
    309       (30 )     11       71       361  
Commercial business
    163       -       -       82       245  
Unallocated
    413       -       -       (172 )     241  
    $ 4,436     $ (875 )   $ 27     $ 828     $ 4,416  

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 reserves 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 OCC, which can order the establishment of additional loss allowances.
 

 
16

 


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

 
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 monthly problem loan reporting.
 
The following table represents the internally assigned grades as of March 31, 2012 by type of loan:
 
   
One-to four- family
   
Home equity
   
Commercial and multifamily
   
Commercial Business
   
Construction and land
   
Manufactured homes
   
Other consumer
   
Total
 
Grade:
 
(in thousands)
 
Pass
  $ 75,775     $ 30,836     $ 99,497     $ 10,528     $ 16,714     $ 15,344     $ 8,978     $ 257,672  
Watch
    16,989       6,346       3,763       2,357       942       2,571       1,163       34,131  
Special Mention
    243       514       603       -       -       54       3       1,417  
Substandard
    5,593       958       1,450       406       570       25       123       9,125  
Doubtful
    -       -       -       -       -       -       -       -  
Loss
    -       -       -       -       -       -       -       -  
Total
  $ 98,600     $ 38,654     $ 105,313     $ 13,291     $ 18,226     $ 17,994     $ 10,267     $ 302,345  

 

 
The following table represents the internally assigned grades as of December 31, 2011 by type of loan:
 

 
   
One-to four- family
   
Home equity
   
Commercial and multifamily
   
Commercial Business
   
Construction and land
   
Manufactured homes
   
Other consumer
   
Total
 
Grade:
 
(in thousands)
 
Pass
  $ 70,392     $ 31,943     $ 100,002     $ 10,331     $ 16,087     $ 16,062     $ 9,507     $ 254,324  
Watch
    18,088       6,138       4,048       2,385       778       2,260       1,312       35,009  
Special Mention
    1,505       183       -       11       -       -       4       1,703  
Substandard
    6,320       1,392       1,966       436       940       122       97       11,273  
Doubtful
    -       -       -       -       -       -       -       -  
Loss
    -       -       -       -       -       -       -       -  
Total
  $ 96,305     $ 39,656     $ 106,016     $ 13,163     $ 17,805     $ 18,444     $ 10,920     $ 302,309  

 

 
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.
 

 
The following table presents the recorded investment in nonaccrual loans as of March 31, 2012 and December 31, 2011 by type of loan:
 
   
March 31, 2012
   
December 31, 2011
 
   
(in thousands)
 
One- to four- family
  $ 2,208     $ 3,124  
Home equity
    745       731  
Commercial and multifamily
    1,203       1,299  
Construction and land
    -       -  
Other consumer
    93       64  
Total
  $ 4,249     $ 5,218  

 

 
17

 


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

 

 
The following table represents the aging of the recorded investment in past due loans as of March 31, 2012 by type of loan:
 
   
30-59 Days Past Due
   
60-89 Days Past Due
   
Greater Than 90 Days Past Due
   
Recorded Investment > 90 Days and Accruing
   
Total Past Due
   
Current
   
Total Loans
 
   
(in thousands)
 
One- to four- family
  $ 3,378     $ -     $ 2,123     $ -     $ 5,501     $ 93,099     $ 98,600  
Home equity
    605       368       440       -       1,413       37,241       38,654  
Commercial and multifamily
    40       -       -       -       40       105,273       105,313  
Construction and land
    -       -       -       -       -       18,226       18,226  
Manufactured homes
    179       44       45       -       268       17,726       17,994  
Other consumer
    159       22       4       -       185       10,082       10,267  
Commercial business
    54       -       -       -       54       13,237       13,291  
Total
  $ 4,415     $ 434     $ 2,612     $ -     $ 7,461     $ 294,884     $ 302,345  

 

 
The following table represents the aging of the recorded investment in past due loans as of December 31, 2011 by type of loan:
 
   
30-59 Days Past Due
   
60-89 Days Past Due
   
Greater Than 90 Days Past Due
   
Recorded Investment > 90 Days and Accruing
   
Total Past Due
   
Current
   
Total Loans
 
   
(in thousands)
 
One- to four- family
  $ 4,321     $ 935     $ 2,683     $ -     $ 7,939     $ 88,366     $ 96,305  
Home equity
    583       176       683       -       1,442       38,214       39,656  
Commercial and multifamily
    -       -       -       -       -       106,016       106,016  
Construction and land
    -       123       80       -       203       17,602       17,805  
Manufactured homes
    327       7       -       -       334       18,110       18,444  
Other consumer
    172       3       -       -       175       10,745       10,920  
Commercial business
    669       -       -       -       669       12,494       13,163  
Total
  $ 6,072     $ 1,244     $ 3,446     $ -     $ 10,762     $ 291,547     $ 302,309  

 

 
Nonperforming Loans.  Loans are considered nonperforming when they are 90 days past due, placed on nonaccrual, or when they are past due troubled debt restructurings.
 

 
The following table represents the credit risk profile based on payment activity as of March 31, 2012 by type of loan:
 
   
One- to four-family
   
Home equity
   
Commercial and multifamily
   
Commercial Business
   
Construction and land
   
Manufactured homes
   
Other consumer
   
Total
 
                                                                                                               (in thousands)
 
Performing
  $ 94,441     $ 37,359     $ 103,264     $ 13,170     $ 18,226     $ 17,994     $ 10,162     $ 294,616  
Nonperforming
    4,159       1,295       2,049       121       -       -       105       7,729  
Total
  $ 98,600     $ 38,654     $ 105,313     $ 13,291     $ 18,226     $ 17,994     $ 10,267     $ 302,345  


 
18

 


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

 
The following table represents the credit risk profile based on payment activity as of December 31, 2011 by type of loan:
 
   
One-to four- family
   
Home equity
   
Commercial and multifamily
   
Commercial Business
   
Construction and land
   
Manufactured homes
   
Other consumer
   
Total
 
                                                                                                              (in thousands)
 
   
Performing
  $ 91,904     $ 38,783     $ 104,797     $ 13,163     $ 17,725     $ 18,444     $ 10,856     $ 295,672  
Nonperforming
    4,401       873       1,219       -       80       -       64       6,637  
Total
  $ 96,305     $ 39,656     $ 106,016     $ 13,163     $ 17,805     $ 18,444     $ 10,920     $ 302,309  
                                                                 

 
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 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.
 

 

 
19

 


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

 
The following table presents loans individually evaluated for impairment as of March 31, 2012 by type of loan:
 
   
Recorded Investment
   
Unpaid Principal Balance
   
Related Allowance
 
With no related allowance recorded:
 
(in thousands)
 
One-to four-family
  $ 3,857     $ 4,117     $ -  
Home equity
    656       797       -  
Commercial and multifamily
    1,834       1,834       -  
Construction and land
    726       726       -  
Manufactured homes
    72       72       -  
Other consumer
    28       69       -  
Commercial business
    825       825       -  
Total
  $ 7,998     $ 8,440     $ -  
                         
With an allowance recorded:
                       
One-to four-family
  $ 5,650     $ 5,878     $ 869  
Home equity
    1,292       1,614       229  
Commercial and multifamily
    425       425       62  
Construction and land
    78       78       18  
Manufactured homes
    797       797       170  
Other consumer
    64       64       7  
Commercial business
    146       146       115  
Total
  $ 8,452     $ 9,002     $ 1,470  
                         
Totals:
                       
One-to four- family
  $ 9,507     $ 9,995     $ 869  
Home equity
    1,948       2,411       229  
Commercial and multifamily
    2,259       2,259       62  
Construction and land
    805       804       18  
Manufactured homes
    904       869       170  
Other consumer
    92       133       7  
Commercial business
    971       971       115  
Total
  $ 16,486     $ 17,442     $ 1,470  


 
20

 


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

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

   
Recorded Investment
   
Unpaid Principal Balance
   
Related Allowance
 
With no related allowance recorded:
 
(in thousands)
 
One-to four-family
  $ 3,104     $ 3,104     $ -  
Home equity
    773       773       -  
Commercial and multifamily
    1,784       1,784       -  
Construction and land
    779       785       -  
Manufactured homes
    -       -       -  
Other consumer
    14       55       -  
Commercial business
    233       233       -  
Total
  $ 6,687     $ 6,734     $ -  
                         
With an allowance recorded:
                       
One-to four-family
  $ 5,156     $ 5,280     $ 541  
Home equity
    1,011       1,038       447  
Commercial and multifamily
    219       219       38  
Construction and land
    123       178       37  
Manufactured homes
    122       122       11  
Other consumer
    87       87       48  
Commercial business
    217       214       132  
Total
  $ 6,932     $ 7,138     $ 1,254  
                         
Totals:
                       
One-to four-family
  $ 8,260     $ 8,384     $ 541  
Home equity
    1,784       1,811       447  
Commercial and multifamily
    2,003       2,003       38  
Construction and land
    902       963       37  
Manufactured homes
    122       122       11  
Other consumer
    101       142       48  
Commercial Business
    447       447       132  
Total
  $ 13,619     $ 13,872     $ 1,254  


 
21

 


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

 
The following table presents loans individually evaluated for impairment as of March 31, 2012 and 2011 by type of loan:
 
   
Three Months Ended
 
   
March 31, 2012
   
March 31, 2011
 
   
Average Recorded Investment
   
Interest Income Recognized
   
Average Recorded Investment
   
Interest Income Recognized
 
With no related allowance recorded:
     
One-to four-family
  $ 3,236     $ 43     $ 1,731     $ 6  
Home equity
    715       12       542       3  
Commercial and multifamily
    1,809       19       453       2  
Construction and land
    740       12       -       -  
Manufactured homes
    13       1       46       -  
Other consumer
    14       1       55       -  
Commercial business
    260       4       147       -  
Total
  $ 6,787     $ 92     $ 2,972     $ 11  
                                 
With an allowance recorded:
                               
One-to four-family
  $ 3,867     $ 48     $ 4,135     $ 7  
Home equity
    885       14       1,069       3  
Commercial and multifamily
    322       2       3,074       32  
Construction and land
    62       1       -       -  
Manufactured homes
    116       15       72       1  
Other consumer
    57       1       35       -  
Commercial business
    180       1       131       3  
Total
  $ 5,489     $ 82     $ 8,516     $ 46  
                                 
Totals:
                               
One-to four-family
  $ 7,103     $ 91     $ 5,866     $ 13  
Home equity
    1,600       26       1,611       6  
Commercial and multifamily
    2,131       21       3,527       34  
Construction and land
    802       13       -       -  
Manufactured homes
    129       16       118       1  
Other consumer
    71       2       90       -  
Commercial Business
    440       5       278       3  
Total
  $ 12,276     $ 174     $ 11,489     $ 57  

 
Forgone interest on nonaccrual loans was $78,000 and $75,000 at March 31, 2012 and 2011, respectively.  There were no commitments to lend additional funds to borrowers whose loans were classified as nonaccrual, TDR or impaired at March 31, 2012 and December 31, 2011.


 
22

 

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

Troubled debt restructurings.  Loans classified as troubled debt restructurings totaled $9.1 million and $6.9 million at March 31, 2012 and December 31, 2011, respectively.  A troubled debt restructuring is a loan to a borrower that is experiencing financial difficulty that has been modified from its original terms and conditions in such a way that the Company is granting the borrower a concession of some kind.  The Company has granted a variety of concessions to borrowers in the form of loan modifications.  The modifications granted can generally be described in the following categories:

Rate Modification: A modification in which the interest rate is changed.

Term Modification: A modification in which the maturity date, timing of payments, or frequency of payments is changed.

Payment Modification: A modification in which the dollar amount of the payment is changed.  Interest only modifications in which a loan in converted to interest only payments for a period of time are included in this category.

Combination Modification:  Any other type of modification, including the use of multiple categories above.

The following table presents newly restructured loans by type of modification:

   
Three Months Ended March 31, 2012
   
Number of Contracts
 
Rate Modifications
 
Term Modifications
 
Payment Modifications
 
Combination Modifications
 
Total Modifications
   
(in thousands, except for number of contracts)
One- to four- family
 
2
 
$-
 
$-
 
$-
 
$88
 
$88
Home equity
 
1
 
-
 
-
 
-
 
49
 
49
Commercial and multifamily
 
1
 
-
 
-
 
-
 
243
 
243
Construction and land
 
-
 
-
 
-
 
-
 
-
 
-
Manufactured homes
 
-
 
-
 
-
 
-
 
-
 
-
Other consumer
 
1
 
-
 
-
 
-
 
12
 
12
Commercial business
 
2
 
121
 
-
 
-
 
160
 
281
Total
 
7
 
$121
 
$
 
$
 
$552
 
$673
                         

There were no post-modification changes that were recorded as a result of the troubled debt restructurings for the year ended March 31, 2012.


 
23

 

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

The following table represents all loans modified as troubled debt restructurings for which there was a payment default in the past 12 months ended March 30, 2012:

   
Quarter ended
March 31, 2012
 
   
(in thousands)
 
One-to four-family
  $ 2,749  
Home equity
    767  
Manufactured homes
    574  
Other consumer
    42  
Commercial business
    540  
Total
  $ 4,672  

For the preceding table, a loan is considered in default when a payment is 30 days or more past due.  One of the one- to four- family first mortgages reached 90 days past due and therefore is on nonaccrual.

The Company had no commitments to extend additional credit to borrowers owing receivables whose terms have been modified in troubled debt restructurings.  All troubled debt restructurings are also classified as impaired loans and are included in the loans individually evaluated for impairment in the calculation of the allowance for loan losses.

 
24

 


SOUND FINANCIAL, INC. AND SUBSIDIARY
Selected Notes to Condensed Consolidated Financial Statements (unaudited)
 
Note 5 – Fair Value Measurements
 

The following table presents estimated fair values of the Company’s financial instruments as of March 31, 2012 and December 31, 2011, whether or not recognized or recorded at fair value is summarized as follows:
 
   
March 31, 2012
   
December 31, 2011
 
Description
 
Carrying
Amount
   
Fair
Value
   
Carrying
Amount
   
Fair
Value
 
Financial assets:
 
(in thousands)
 
 Cash and cash equivalents
  $ 25,409     $ 25,409     $ 17,031     $ 17,031  
 Available for sale securities
    3,035       3,035       2,992       2,992  
  FHLB Stock
    2,444       2,444       2,444       2,444  
 Loans held for sale
    1,139       1,139       1,807       1,807  
 Loans, net
    296,393       298,276       295,641       297,358  
 Accrued interest receivable
    1,153       1,153       1,234       1,234  
  Bank owned life insurance, net
    7,047       7,047       6,981       6,981  
  Mortgage servicing rights
    2,791       2,791       2,437       2,437  
                                 
Financial liabilities:
                               
Non-maturity deposits
    171,881       171,881       170,029       170,029  
Time deposits
    135,896       136,309       129,968       130,672  
Borrowings
    8,346       8,126       8,506       8,451  
Accrued interest payable
    82       82       84       84  
Advance payments from borrowers for taxes and insurance
    579       579       291       291  

The following table presents information about the level in the fair value hierarchy for the Company’s assets and liabilities that are not measured at fair value as of March 31, 2012:

   
Fair Value at March 31, 2012
 
Description
 
Total
   
Level 1
   
Level 2
   
Level 3
 
ASSETS
 
(in thousands)
 
Cash and cash equivalents
  $ 25,409     $ 25,409     $ -     $ -  
FHLB Stock
    2,444       -       -       2,444  
Loans held for sale
    1,139       -       1,139       -  
Loans, net
    298,276       -       298,276       -  
Accrued interest receivable
    1,153       -       -       1,153  
Bank owned life insurance, net
    7,047       7,047       -       -  
                                 
LIABILITIES
                               
Non-maturity deposits
  $ 171,881     $ -     $ -     $ 171,881  
Time deposits
    136,309       -       136,309       -  
Accrued interest payable
    82       -       -       82  
Advance payments from borrowers for taxes and insurance
    579       -       -       579  

 
25

 


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

The following table presents information about the Company’s assets measured at fair value on a recurring basis as of March 31, 2012 and December 31, 2011:

   
Fair Value at March 31, 2012
 
Description
 
Total
   
Level 1
   
Level 2
   
Level 3
 
   
(in thousands)
 
Agency Mortgage-backed Securities
  $ 58     $ -     $ 58     $ -  
Non-agency Mortgage-backed Securities
    2,977       -       2,977       -  
Mortgage Servicing Rights
    2,791       -               2,791  
   
   
Fair Value at December 31, 2011
 
Description
 
Total
   
Level 1
   
Level 2
   
Level 3
 
   
(in thousands)
 
Agency Mortgage-backed Securities
  $ 59     $ -     $ 59     $ -  
Non-agency Mortgage-backed Securities
    2,933       -       2,933       -  
Mortgage Servicing Rights
    2,437       -       -       2,437  

For the three months ended March 31, 2012, there were no transfers between Level 1 and Level 2 or between Level 2 and Level 3.

The following table provides a description of the valuation technique, unobservable input, and qualitative information about the unobservable inputs for the Company’s assets and liabilities classified as Level 3 and measured at fair value on a recurring basis at March 31, 2012:

Financial Instrument
 
Valuation Technique
 
Unobservable Inputs
 
Weighted Average
Mortgage Servicing Rights
 
Discounted cash flow
 
Prepayment Speed Assumption
Discount rate
 
331.0%
9.0%

Generally, any significant increases in the constant prepayment rate and discount rate utilized in the fair value measurement of the mortgage servicing rights will result in a negative fair value adjustment (and decrease in the fair value measurement).  Conversely, a decrease in the constant prepayment rate and discount rate will result in a positive fair value adjustment (and increase in the fair value measurement).  An increase in the weighted average life assumptions will result in a decrease in the constant prepayment rate and conversely, a decrease in the weighted average life will result in an increase of the constant prepayment rate.

 
26

 


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


The following table presents information about the Company’s assets measured at fair value on a nonrecurring basis:

   
Fair Value at March 31, 2012
 
   
Total
   
Level 1
   
Level 2
   
Level 3
 
Description
 
(in thousands)
OREO and Repossessed Assets
  $ 2,065     $ -     $ -     $ 2,065  
Impaired Loans
    16,537       -       -       16,537  
 
   
Fair Value at December 31, 2011
 
   
Total
   
Level 1
   
Level 2
   
Level 3
 
Description
 
(in thousands)
OREO and Repossessed Assets
  $ 2,821     $ -     $ -     $ 2,821  
Impaired Loans
    13,619       -       -       13,619  

The following table presents the total losses resulting from fair value adjustments (in thousands):
 
Description
 
Year Ended
March 31, 2011
Total Losses
   
Year Ended
March 31, 2011
Total Losses
 
OREO and repossessed Assets
  $ 469     $ 45  
Impaired Loans
    1,615       38  
                 

There were no liabilities carried at fair value, measured on a recurring or nonrecurring basis, at March 31, 2012 or December 31, 2011.

A description of the valuation methodologies used for impaired loans and OREO is as follows:

Impaired Loans - The fair value of collateral dependent loans is based on the current appraised value of the collateral or internally developed models utilizing a calculation of expected discounted cash flows 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 methods and assumptions were used to estimate fair value of each class of financial instruments listed above:
 

 
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.
 
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 private label mortgage-backed securities.
 


 
27

 


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

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 loan 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, 2012, loans held for sale were carried at cost.
 

 
Mortgage Servicing Rights – Mortgage servicing rights represent the value associated with servicing residential mortgage loans, when the mortgage loans have been sold into the secondary market and the related servicing has been retained by us. The value is determined though a discounted cash flow analysis, which uses interest rates, prepayment speeds and delinquency rate assumptions as inputs. All of these assumptions require a significant degree of management judgment. Servicing rights and the related mortgage loans are segregated into categories of homogeneous pools based upon common characteristics. Mortgage servicing rights 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 borrowings 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.
 

 
28

 


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


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, 2012 and 2011 (in thousands):

   
Mortgage
Servicing
Rights
 
       
Beginning balance as of January 1, 2012
  $ 2,437  
Servicing rights that result from transfers of financial assets
    185  
Changes in Fair Value(1)
    384  
Other(2)
    (215 )
Fair Value as of March 31, 2012
  $ 2,791  

   
Mortgage
Servicing
Rights
 
       
Beginning balance at January 1, 2011
  $ 3,200  
Servicing rights that result from transfers of financial assets
    148  
Changes in Fair Value(1)
    (1 )
Other(2)
    (201 )
Fair Value as of March 31, 2011
  $ 3,148  

(1) Represents changes due to principal collections over time
(2) Primarily relates to changes in prepayment speeds, duration and discount rate

 
Note 6 – 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.
 

 
29

 


SOUND FINANCIAL, INC. AND SUBSIDIARY
Selected Notes to Condensed Consolidated Financial Statements (unaudited)
 
Note 7 – 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 and multifamily portfolio based on the outstanding balance. At March 31, 2012, the amount available to borrow under this agreement is approximately 35% of total assets, or up to $122.0 million subject to the availability of eligible collateral.  Based on eligible collateral, the total amount available under this agreement as of March 31, 2012 and December 31, 2011 was $90.3 million and $83.5 million, respectively.  The Company had outstanding borrowings under this arrangement of $8.3 million and $8.5 million at March 31, 2012 and December 31, 2011, respectively.  Additionally, the Company has outstanding letters of credit from the FHLB with a notional amount of $29.0 million and $24.0 million at March 31, 2012 and December 31, 2011, respectively, to secure public deposits.  The net remaining amounts available as of March 31, 2012 and December 31, 2011, were $52.9 million and $51.0 million, 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 $10.3 million and $21.9 million at March 31, 2012 and December 31, 2011, respectively.  There were no outstanding borrowings at March 31, 2012 or December 31, 2011.

The Company has access to an unsecured line of credit from the Pacific Coast Banker’s Bank.  The line has a one-year term maturing on June 30, 2012 and is renewable annually.  As of March 31, 2012, the amount available under this line of credit is $2.0 million.  There was no outstanding balance on this line of credit as of March 31, 2012 and December 31, 2011.

 
Note 8 – 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,
 
   
2012
   
2011
 
Net income
  $ 546     $ 496  
Less net income attributable to participating securities(1)
    9       8  
Net income available to common shareholders
  $ 537     $ 488  
                 
Weighted average number of shares outstanding, basic
    2,886       2,921  
                 
Earnings per share, basic
  $ 0.19     $ 0.17  
Earnings per share, diluted
  $ 0.19     $ 0.17  

(1) Represents dividends paid and undistributed earnings allocated to nonvested restricted stock awards.

For the periods ended March 31, 2012 and 2011, all options were considered antidilutive and excluded in the calculation for earnings per share.

 
30

 


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

 
Note 9 – Stock-based Compensation

Stock Options and Restricted Stock
 
In 2008, the Board of Directors adopted and stockholders 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. Restricted stock and stock option awards generally vest in 20 percent annual increments commencing one year from the grant date. Options are exercisable for a period of 10 years from the date of grant, subject to vesting. 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.
 
During the periods ended March 31, 2012 and 2011, share based compensation expense totaled $33,000 and $33,000, respectively, for both stock options and restricted stock. The tax benefit recognized in the consolidated statement of income for the periods ended March 31, 2012 and 2011 was $11,000 and $11,000, respectively. There was no cash received from exercise of options for the periods ended March 31, 2012 and 2011. There was no tax benefit realized for tax deductions from option exercises for the periods ended March 31, 2012 and 2011.
The following is a summary of the Company’s stock option plan awards during the period ended March 31, 2012:

   
Shares
   
Weighted-Average Exercise Price
   
Weighted-Average Remaining Contractual Term In Years
   
Aggregate Intrinsic Value
 
Outstanding at the beginning of the year
    95,438     $ 7.93       6.83     $ 7,158  
Granted
    30,212       7.42       9.92       2,417  
Exercised
    -       -                  
Forfeited or expired
    -       -                  
Outstanding at March 31, 2012
    125,650     $ 7.81       7.57     $ 9,575  
Exercisable
    52,139     $ 7.93       7.57          
Expected to vest, assuming a 0% forfeiture rate over the vesting term
    125,650     $ 7.81       7.57          

 

 
31

 

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

No options for shares of common stock remain available for grant under the Plan.
 
The fair value of each option award is estimated on the date of grant using a Black-Scholes model that uses the assumptions noted in the table below.  The dividend yield is based on the current quarterly dividend in effect at the time of the grant, adjusted for future expectations. The Company became a publicly held company in January 2008, so the amount of historical stock price information available is limited.  As a result, the Company elected to use a weighted-average of its peers’ historical stock prices, as well as the Company’s own historical stock prices to estimate volatility.  The Company bases the risk-free interest rate on the U.S. Treasury Constant Maturity Indices in effect on the date of the grant.  The Company elected to use the Staff Accounting Bulletin No. 110, “Share-Based Payments” permitted by the Securities and Exchange Commission to calculate the expected term.  This simplified method uses the vesting term of an option along with the contractual term, setting the expected life at a midpoint in between.

The fair value of options granted during 2012 were determined using the following weighted-average assumptions as of the grant date.
 
Annual dividend yield
 
2.00
%
Expected volatility
 
30.00
%
Risk-free interest rate
 
1.36
%
Expected term
 
                                                                           7.5 years
Weighted-average grant date fair value per option granted
 
$                                                                             2.50
 
 
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.
 
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, 2012:
 
 
Nonvested Shares
 
 
Shares
   
Weighted-Average Grant-Date Fair Value Per Share
   
Aggregate Intrinsic Value Per Share
 
                   
Non-vested at January 1, 2012
    25,972     $ 7.35        
Granted
    11,000       7.42        
Vested
    8,656       7.35        
Forfeited
    -       -        
Non-vested at March 31, 2012
    28,316     $ 7.38     $ 7.50  
                         
Expected to vest assuming a 0% forfeiture rate over the vesting term
    28,316     $ 7.38     $ 7.50  

The aggregate intrinsic value of the nonvested restricted stock awards as of March 31, 2012 was $212,000.

As of March 31, 2012, there was $241,000 of unrecognized compensation cost related to nonvested restricted stock awards granted under the Plan remaining.  The cost is expected to be recognized over the weighted-average vesting period of 3.11 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.


 
32

 


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

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 by the Bank through 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, 2012, the remaining balance of the ESOP loan was $751,000.  Neither the loan nor the related interest is reflected on the condensed consolidated financial statements.

At March 31, 2012, the ESOP was committed to release 11,556 shares of the Company’s common stock to participants and held 92,448 unallocated shares remaining to be released in future years.  The fair value of the 92,448 restricted shares held by the ESOP trust was $693,000 at March 31, 2012.  ESOP compensation expense included in salaries and benefits was $25,000 for the three month period ended March 31, 2012.

 
33

 


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. (“Sound Financial”) is a federally chartered stock holding company and is subject to regulation by the Board of Governors of the Federal Reserve System (“Federal Reserve”).  Sound Financial was incorporated on January 8, 2008, as part of Sound Community Bank’s reorganization into the mutual holding company form of organization.  As part of the reorganization, Sound Community Bank (i) converted to a stock savings bank as the successor to Sound Community Bank in its mutual form (which was originally chartered as a credit union in 1953); (ii) organized Sound Financial, which owns 100% of the common stock of Sound Community Bank; and (iii) organized Sound Community MHC, which acquired 55.0% of the common stock of Sound Financial in the reorganization.  Sound MHC has no other activities or operations other than its ownership of Sound Financial. Sound Financial has no significant assets other than all of the outstanding shares of common stock of Sound Community Bank, its loan to our Employee Stock Ownership Plan and certain liquid assets.

On January 27, 2012, the boards of Sound Financial, Sound Community Bank and Sound Community MHC adopted a plan to reorganize into a full stock company and undertake a “second step” offering of new shares of common stock.  The reorganization and offering, which is subject to regulatory, shareholder and depositor approval, is expected to be completed during the third quarter of 2012.  As part of the reorganization, Sound Community Bank will become a wholly owned subsidiary of Sound Financial Bancorp, Inc., a newly formed Maryland stock corporation incorporated in March 2012.  Shares of common stock of Sound Financial, other than those held by Sound Community MHC, will be converted into shares of common stock in Sound Financial Bancorp, Inc. using an exchange ratio designed to preserve current stockholders’ (other than Sound Community MHC) percentage ownership interests in Sound Financial, Inc. Shares owned by Sound Community MHC will be retired, and new shares representing that ownership will be offered and sold to Sound Community Bank’s eligible depositors, Sound Community Bank’s tax-qualified employee benefit plans and members of the general public as set forth in the Plan of Conversion and Reorganization of Sound Community MHC.  The Plan of Conversion and Reorganization of Sound Community MHC was filed on January 30, 2012 with the SEC in a Current Report on Form 8-K.

Substantially all of Sound Financial’s business is conducted through Sound Community Bank, which is a federal savings bank subject to extensive regulation by the Office of the Comptroller of the Currency (“OCC”). Sound Community Bank’s deposits are insured up to applicable limits by the Federal Deposit Insurance Corporation (“FDIC”).  At March 31, 2012, Sound Financial had total consolidated assets of $348.7 million, net loans of $296.4 million, deposits of $307.8 million and stockholders’ equity of $29.5 million. Shares of Sound Financial’s common stock are traded on the OTC Bulletin Board under the symbol “SNFL.” Our executive offices are located at 2005 5th Avenue – Suite 200, Seattle, Washington, 98121.

Our principal business consists of attracting retail deposits from the general public and investing those funds, along with borrowed funds, in loans secured by first and second mortgages on one- to four-family residences (including home equity loans and lines of credit), commercial and multifamily, consumer and commercial business loans and, to a lesser extent, construction and land loans.  We offer a wide variety of secured and unsecured consumer loan products, including manufactured home loans, automobile loans, boat loans and recreational vehicle loans.  As part of our business, we focus on residential mortgage loan originations, many of which we sell to Fannie Mae. We sell these loans with servicing retained to maintain the direct customer relationship and promote our emphasis on strong customer service.

Our operating revenues are derived principally from earnings on interest earning assets, service charges and fees, and gains on the sale of loans and other assets.  Our primary sources of funds are deposits, Federal Home Loan Bank (“FHLB”) advances and other borrowings, and payments received on loans and securities. We offer a variety of deposit accounts that provide a wide range of interest rates and terms, generally including savings, money market, term certificate and demand accounts.


 
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Our noninterest expenses consist primarily of salaries and employee benefits, expenses for occupancy, marketing and computer services and FDIC deposit insurance premiums.  Salaries and benefits consist primarily of the salaries and wages paid to our employees, payroll taxes, expenses for retirement and other employee benefits.  Occupancy expenses, which are the fixed and variable costs of buildings and equipment, consist primarily of lease payments, property taxes, depreciation charges, maintenance and costs of utilities

Forward-Looking Statements
 
When used in this Form 10-Q 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.  Forward-looking statements include statements with respect to our beliefs, plans, objectives, goals, expectations, assumptions and statements about future performance.  These forward-looking statements are subject to known and unknown risks, uncertainties and other factors that could cause actual results to differ materially from the results anticipated, including, among other things,

·  
changes in economic conditions, either nationally or in our market area;
 

 
·  
fluctuations in interest rates;
 

 
·  
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 our allowance for loan losses;
 

·  
the possibility of other-than-temporary impairments of securities held in our securities portfolio;
 

 
·  
our ability to access cost-effective funding;
 

 
·  
fluctuations in the demand for loans, the number of unsold homes, land and other properties, and fluctuations in real estate values and both residential and commercial and multifamily real estate market conditions in our market area;
 

·  
secondary market conditions for loans and our ability to sell loans in the secondary market;
 

 
·  
our ability to attract and retain deposits;
 

 
·  
our ability to successfully integrate any assets, liabilities, customers, systems, and management personnel we may acquire into our operations and our ability to realize related revenue synergies and expected cost savings and other benefits within the anticipated time frames or at all;
 

·  
legislative or regulatory changes that adversely affect our business including changes in regulatory policies and principles, or the interpretation of regulatory capital or other rules;
 

·  
monetary and fiscal policies of the Federal Reserve and the U.S. Government and other governmental initiatives affecting the financial services industry;
 

·  
results of examinations of Sound Financial and Sound Community Bank by their regulators, including the possibility that the regulators may, among other things, require us to increase our allowance for loan losses or to write-down assets, change Sound Community Bank’s regulatory capital position or affect our ability to borrow funds or maintain or increase deposits, which could adversely affect our liquidity and earnings;
 

·  
increases in premiums for deposit insurance;
 

 
·  
our ability to control operating costs and expenses;
 


 
35

 


·  
the use of estimates in determining fair value of certain of our assets, which estimates may prove to be incorrect and result in significant declines in valuation;

·  
difficulties in reducing risks associated with the loans on our balance sheet;

·  
staffing fluctuations in response to product demand or the implementation of corporate strategies that affect our workforce and potential associated charges;

·  
computer systems on which we depend could fail or experience a security breach;

·  
our ability to retain key members of our senior management team;

·  
costs and effects of litigation, including settlements and judgments;

·  
our ability to implement our business strategies;

·  
increased competitive pressures among financial services companies;

·  
changes in consumer spending, borrowing and savings habits;

·  
the availability of resources to address changes in laws, rules, or regulations or to respond to regulatory actions;
·  
 
·  
our ability to pay dividends on our common stock;

·  
adverse changes in the securities markets;

·  
the inability of key third-party providers to perform their obligations to us;

·  
changes in accounting policies and practices, as may be adopted by the financial institution regulatory agencies or the Financial Accounting Standards Board, including additional guidance and interpretation on accounting issues and details of the implementation of new accounting methods; and

·  
other economic, competitive, governmental, regulatory, and technological factors affecting our operations, pricing, products and services and the other risks described from time to time in our filings with the Securities and Exchange Commission (“SEC”).

We wish to advise readers not to place undue reliance on any forward-looking statements and that the factors listed above could materially affect our financial performance and could cause our actual results for future periods to
differ materially from any such forward-looking statements expressed with respect to future periods and could negatively affect our stock price performance.

We do not undertake and specifically decline 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 of anticipated or unanticipated events.

References in this document to “we,” “us,” and “our” means Sound Financial, Inc. and its wholly-owned subsidiary, Sound Community Bank, unless the context otherwise requires.

 
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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 servicing 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, 2011.
 
Comparison of Financial Condition at March 31, 2012 and December 31, 2011
 
General.  Total assets increased by $9.0 million, or 2.6%, to $348.7 million at March 31, 2012 from $339.7 million at December 31, 2011.  This increase was primarily the result of a $8.4 million, or 49.2% increase in cash and cash equivalents, a $944,000, or 23.8% increase in other assets and a $752,000, or 0.3% increase in our net loan portfolio offset partially by a $756,000, or 26.8% decrease in OREO and other repossessed assets and a $668,000, or 37.0% decrease in loans held for sale.  Our total liabilities increased by $8.2 million or 2.6% to $319.2 million at March 31, 2012 from $311.0 million at December 31, 2011.  This increase was primarily the result of a $7.8 million, or 2.6% increase in deposits, a $299,000, or 13.9% increase in other liabilities and a $288,000, or 99.0% increase in advance payments from borrowers.
 
Cash and Securities.  Cash, cash equivalents and our available-for-sale securities increased $8.4 million, or 42.1%, to $28.4 million at March 31, 2012.  Cash and cash equivalents increased by $8.4 million, or 49.2%, to $25.4 million at March 31, 2012, as increased deposits exceeded pay-downs on borrowed funds and net loan production.  Available-for-sale securities, which consist primarily of non-agency mortgage-backed securities, remained relatively unchanged, increasing by $43,000, or 1.4%, to $3.0 million at March 31, 2012.  This increase reflects improved market valuations on our portfolio which were offset by investment pay-downs and impairment charges on our non-agency mortgage-backed security portfolio.
 
At March 31, 2012, our available-for-sale securities portfolio consisted primarily of $3.0 million of non-agency mortgage-backed securities.  These securities present a higher credit risk than U.S. agency mortgage-backed securities, of which we had $58,000 at March 31, 2012.  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 credit scores, loan-to-value ratios, geographic locations, delinquencies and loss histories of the underlying mortgage loans.  This analysis is prepared 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 2012, recorded an impairment charge of $91,000 on four 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 to change significantly in 2012.  Accordingly, if the market and economic environment impacting the loans supporting these securities continues to deteriorate, we could determine that additional impairment must be recorded on these securities, as well as on any other securities in our portfolio.  As a result, our future earnings, equity, regulatory capital and ongoing operations could be materially adversely affected.
 
Loans.  Our total loan portfolio, including loans held for sale, remained relatively unchanged, decreasing $21,000, or 0.01%, to $301.9 million at March 31, 2012.  Loans held for sale decreased from $1.8 million at December 31, 2011, to $1.1 million at March 31, 2012, reflecting the timing of origination and sales transactions late in first quarter of 2012, as compared to late 2011.
 
The most significant changes in our loan portfolio during the quarter included an increase of $2.3 million or 2.4% in our one-to four-family loans, and a $1.0 million or 2.5% decrease in home equity loans and lines of credit consistent with our emphasis on refinancing home equity loan balances into first position one-to four-family loans.  In addition, manufactured home loans decreased by $450,000 or 2.4% while other consumer loans decreased $653,000 or 6.0% between December 31, 2011 and March 31, 2012 primarily as a result of charge-offs and lower demand from creditworthy borrowers in the current economic environment.
 
 
The following table reflects the changes in the types of loans in our loan portfolio at March 31, 2012 as compared to the end of 2011:
 
   
March 31, 2012
   
December
31, 2011
   
Amount Change
   
Percent Change
 
   
(Dollars in thousands)
 
One-to-four family loans
  $ 98,600     $ 96,305     $ 2,295       2.4 %
Home equity
    38,654       39,656       (1,002 )     (2.5 )
Commercial and multifamily
    105,313       106,016       (703 )     (0.7 )
Construction and land
    18,226       17,805       421       2.4  
Manufactured homes
    17,994       18,444       (450 )     (2.4 )
Other consumer
    10,276       10,920       (644 )     (5.9 )
Commercial business
    13,291       13,163       128       1.0  
Total
  $ 302,345     $ 302,309     $ (36 )     (0.0 )%

Mortgage Servicing Rights.  At March 31, 2012, we had $2.8 million in mortgage servicing rights recorded at fair value compared to $2.4 million at December 31, 2011.  The increase during the period was the result of a higher market valuation on the portfolio and an increase in our originated servicing portfolio as of March 31, 2012 compared to December 31, 2011.
 
Nonperforming Assets.  At March 31, 2012, our nonperforming assets totaled $9.8 million, or 2.81% of total assets, compared to $9.5 million, or 2.78% of total assets at December 31, 2011.
 
Nonperforming loans to total loans increased to 2.57% of total loans at March 31, 2012 from 2.20% at December 31, 2011.  This increase reflects a $1.1 million increase in nonperforming loans primarily due to the addition of several one- to four- family loans that became nonperforming in the first quarter of 2012 and the continuing weak economy in our market area.
 
Our largest nonperforming loans at March 31, 2012 consisted of a $1.2 million commercial real estate loan, a $988,000 one-to four-family loan and a $686,000 one-to four-family loan.  We do not expect any material losses on these nonperforming assets in 2012 that have not been previously identified based on current appraisals and valuation estimates.
 
OREO and repossessed assets decreased during the first quarter of 2012 primarily due to the sale of an $873,000 commercial property as well as a $210,000 write down on an OREO property still in our possession as of March 31, 2012.  During the quarter, we repossessed four personal residences and three manufactured homes.  We sold two personal residences, one commercial property and three manufactured homes at an aggregate loss of $10,000.  Our largest OREO at March 31, 2012, consisted of a mobile home park with a recorded value of $1.0 million in Spanaway, Washington.  Our next two largest OREO properties were comprised of a $309,000 commercial property in Sequim, Washington and a $249,000 personal residence in Dayton, Washington.  We do not expect to experience a material loss on any of the OREO and repossessed assets in our possession at March 31, 2012 based on current appraisals and valuation estimates.
 

 
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The table below sets forth the amounts and categories of nonperforming assets in our loan portfolio at the dates indicated
 

 
38

 


 
   
Nonperforming Assets
 
   
March 31,
 2012
   
December 31, 2011
   
Amount
Change
 
Percent
Change
 
   
(Dollars in thousands)
 
Nonperforming loans(1):
                       
One-to four- family
  $ 4,159     $ 4,401     $ (242 )     (5.5 )%
Home equity
    1,135       873       262       30.0  
Commercial and multifamily
    1,806       1,219       587       48.2  
Construction and land
    -       80       (80 )     (100.0 )
Other consumer
    105       64       41       64.1  
Commercial business
    524       -       524    
NM
 
Total
  $ 7,729     $ 6,637     $ 1,092       16.5 %
                                 
OREO and repossessed assets:
                               
One-to four- family
  $ 592     $ 478     $ 114       23.8 %
Commercial and multifamily
    1,348       2,225       (877 )     (39.4 )%
Manufactured homes
    125       118       7       5.9 %
Total
  $ 2,065     $ 2,821     $ (756 )     26.7 %
                                 
Total nonperforming assets
  $ 9,794     $ 9,458     $ 336       3.5 %
Nonperforming assets as a percentage of total assets
    2.80 %     2.78 %                
                                 
Performing restructured loans:
                               
One-to four- family
  $ 3,563     $ 2,508     $ 1,055       42.1 %
Home equity
    620       812       (192 )     (23.6 )
Commercial and multifamily
    178       785       (606 )     (77.2 )
Construction and land
    78       -       78    
NM
 
Manufactured homes
    734       -       734    
NM
 
Other consumer
    51       4       47       1175.0  
Commercial business
    405       26       379       1457.7  
Total
  $ 5,630     $ 4,135     $ 1,495       36.2 %
(1)  
Nonperforming loans include $3.5 million and $2.8 million in nonperforming TDRs as of March 31, 2012 and December 31, 2011.

 
39

 

In addition to the non-performing assets set forth in the table above, as of March 31, 2012, there were $3.0 million in loans with respect to which known information about 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.  This may result in the future inclusion of such loans in the nonperforming asset categories.
 
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 best estimate of probable incurred credit losses in our loan portfolio.
 
Our allowance for loan losses at March 31, 2012 was $4.3 million, or 1.45% of total loans receivable, compared to $4.5 million, or 1.47% of total loans receivable at December 31, 2011.  The $105,000, or 2.4% decrease in the allowance for loan losses reflects the $1.5 million provision for loan losses established during the first quarter of 2012 as a result of the increase in nonperforming loans and  charge-offs of $1.6 million during the quarter.
 

Specific loan loss reserves increased $216,000, while general loan loss reserves decreased by $321,000 at March 31, 2012 compared to December 31, 2011.  Net charge-offs for the three months ending March 31, 2012 were $1.6 million, or 2.14% of average loans on an annualized basis, compared to $802,000, or 1.06% of average loans for 2011.  The increase in net charge-offs was primarily due to the weak economic conditions in our market area.  As of March 31, 2012, the allowance for loan losses as a percentage of loans receivable and nonperforming loans was 1.45% and 56.28%, respectively, compared to 1.47% and 67.12%, respectively, at December 31, 2011.  Allowance for loan losses as a percentage of loans receivable decreased slightly due to the increase in charge-offs during the period.  The allowance for loan losses as a percentage of nonperforming loans decreased due to the increase in nonperforming loans.
 
The following table shows the adjustments in our allowance during the first three months of 2012 as compared to the same period in 2011:
 
   
At and for the Period Ended
 March 31,
 
   
2012
   
2011
 
   
(Dollars in thousands)
 
Balance at beginning of period
  $ 4,455     $ 4,436  
Charge-offs
    (1,615 )     (875 )
Recoveries
    10       30  
Net charge-offs
    (1,605 )     (845 )
Provisions charged to operations
    1,500       825  
Balance at end of period
  $ 4,350     $ 4,416  
                 
Ratio of net charge-offs during the period to average loans outstanding during the period
    2.14 %     1.14 %
                 
Allowance as a percentage of non-performing loans
    56.3       72.2 %
                 
Allowance as a percentage of total loans (end of period)
    1.45 %     1.49 %

Deposits.  Total deposits increased by $7.8 million, or 2.6%, to $307.8 million at March 31, 2012 from $300.0 million at December 31, 2011.  During the first three months of 2012, public deposits increased $4.7 million, noninterest-bearing and interest-bearing checking accounts increased $1.4 million and $2.8 million, respectively.  These increases were offset by a $1.9 million decrease in consumer certificates of deposit.  Our noninterest-bearing and interest-bearing checking account increases were a result of our increased emphasis on attracting these and other low cost deposit accounts such as savings accounts.  Decreases in consumer certificates of deposit were due to the low interest rate environment as maturing certificates migrated to other account types or investments.
 
A summary of deposit accounts with the corresponding weighted average cost of funds is presented below
 
   
As of March 31, 2012
   
As of December 31, 2011
 
   
Amount
   
Wtd. Avg.
Rate
   
Amount
   
Wtd. Avg.
Rate
 
   
(Dollars in thousands)
 
Checking (noninterest)
  $ 28,282       0.00 %   $ 26,907       0.00 %
NOW (interest)
    25,141       0.08       22,332       0.09  
Savings
    23,446       0.06       22,092       0.10  
Money Market
    91,040       0.33       95,029       0.58  
Certificates
    135,896       1.33       129,968       1.53  
Escrow
    3,972       0.00       3,669       0.00  
Total
  $ 307,777       0.69 %   $ 299,997       0.87 %

 
Borrowings.  FHLB advances decreased $160,000, or 1.9%, to $8.3 million at March 31, 2012, with a weighted-average cost of 2.16%, from $8.5 million at December 31, 2011, with a weighted-average cost of 2.17%. We continue to utilize FHLB advances to fund interest-earning asset growth and/or enhance our interest rate risk management despite our strong deposit growth.  This reliance on borrowings, rather than deposits, may increase our overall cost of funds.  We decreased reliance on these borrowings during 2011 and the first quarter of 2012 as our deposit growth exceeded loan growth.
 
Stockholders’ Equity.  Total stockholders’ equity increased $753,000, or 2.6%, to $29.5 million at March 31, 2012, from $28.7 million at December 31, 2011.  This primarily reflects $546,000 in net income as well as increases in paid in capital and a decrease in accumulated other comprehensive loss.
 
Comparison of Results of Operation for the Three Months Ended March 31, 2012 and 2011
 
General. Net income increased $50,000 to $546,000 for the quarter ended March 31, 2012, compared to $496,000 for the quarter ended March 31, 2011. The primary reasons for this improvement were an increase in net interest income and non-interest income, partially offset by an increase in the provision for loan losses.
 
Interest Income. Interest income decreased by $85,000, or 1.8%, to $4.6 million for the quarter ended March 31, 2012 compared to the quarter ended March 31, 2011.  The decrease in interest income primarily reflected lower interest rates realized on our loan portfolio despite the increase in our average loan balances during the first quarter of 2012 as compared to the same period last year.
 
The weighted average yield on loans decreased from 6.18% for the quarter ended March 31, 2011, to 6.01% for the quarter ended March 31, 2012.  The decrease was primarily the result of the continued historically low interest rate environment and the competitive market for 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 7.48% for the quarter ended March 31, 2012 compared to 6.45% for the quarter ending March 31, 2011, reflecting sales of lower yielding non-agency mortgage-backed securities in 2011.
 
Interest Expense.  Interest expense decreased $151,000, or 20.1%, to $601,000 for the quarter ended March 31, 2012, from $752,000 for the quarter ended March 31, 2011.  This decrease reflects overall lower interest rates paid on deposits and FHLB advances notwithstanding an increase in the average balances of deposits during the period.  Our weighted average cost of interest-bearing liabilities was 0.86% for the quarter ended March 31, 2012, compared to 1.11% for the quarter ended March 31, 2011.
 
Interest paid on deposits decreased $102,000, or 15.8% to $546,000 for the quarter ended March 31, 2012, from $648,000 for the same period in 2011. This decrease resulted from a decrease in the weighted average cost of deposits, which was offset by a $24.9 million increase in the average balance of deposits outstanding for the period.  We experienced a 21 basis point decrease in the average rate paid on deposits during the quarter ended March 31, 2012 compared to same period in 2011.  This decrease in average rates was a result of the re-pricing of matured certificates of deposit, most of which we were 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 our emphasis on attracting lower-cost core deposits.
 
Interest expense on borrowings decreased $49,000, or 47.1%, to $55,000 for the quarter ended March 31, 2012 from $104,000 for the quarter ended March 31, 2011.  The decrease resulted primarily from a $13.0 million decrease in the average balance of borrowings outstanding.  We experienced a 67 basis point increase in our average cost of borrowings from 1.95% during the quarter ended March 31, 2011 compared to 2.62% during the quarter ended March 31, 2012.  This increase in our average cost was a result of the maturity of lower cost borrowings and a payoff of overnight borrowings which had a lower cost than our term borrowings in 2011.
 
Net Interest Income.  Net interest income increased $66,000, or 1.7% to $4.0 million for the quarter ended March 31, 2012, from $3.9 million for the quarter ended March 31, 2011.  The increase in net interest income for the 2012 period primarily resulted from lower rates paid on deposits and lower outstanding borrowings during the first quarter of 2012 compared to the first quarter of 2011. Our net interest margin was 5.23% for the quarter ended March 31, 2012, compared to 5.18% for the quarter ended March 31, 2011.
 
Provision for Loan Losses.  A provision for loan losses of $1.5 million was made during the quarter ended March 31, 2012, compared to a provision for loan losses of $825,000 during the quarter ended March 31, 2011.  The increase in the provision for loan losses reflects increases in our net charge-offs and nonperforming loans.  We believe that higher than historical levels of nonperforming assets and charge-offs will continue until the housing market, unemployment, and general economic market conditions further recover in our market area.
 

 
40

 


For the quarter ended March 31, 2012, the annualized percentage of net charge-offs to average loans increased 100 basis points to 2.14% from 1.14% for the quarter ended March 31, 2011.  The ratio of nonperforming loans to total loans increased from 2.06% at March 31, 2011 to 2.57% at March 31, 2012.
 
Noninterest Income.  Noninterest income increased $658,000, or 96.9%, to $1.3 million during the quarter ended March 31, 2012, compared to $679,000 during the quarter ended March 31, 2011.  This increase was primarily as the result of a higher fair value adjustment on mortgage servicing rights and higher gains on the sale of one-to-four family loans on the secondary market. Also, mortgage servicing income increased as the result of a deceleration of the amortization of acquired and capitalized mortgage servicing rights.  The fair value adjustment on mortgage servicing rights was also positively impacted by the interest rate environment, as rates increased during the quarter and prepayment speeds slowed, which directly impacts the market value.  The gain on sale of loans increased as the result of more originated and sold loans to Fannie Mae during the first quarter of 2012 compared to the first quarter of 2011.
 
A summary of the changes in noninterest income is presented in the table below:
 
   
Quarter Ended
March 31,
             
   
2012
   
2011
   
Amount Change
   
Percent Change
 
   
(Dollars in thousands)
 
Service charges and fee income
  $ 550     $ 522     $ 28       5.3 %
Earnings on cash surrender value of bank owned life insurance
    66       62       4       6.5  
Mortgage servicing income
    177       135       42       31.1  
Fair value adjustment  on mortgage servicing rights
    384       (1 )     385       385.0  
Loss on sale of securities
    -       (34 )     34       100.0  
Other-than-temporary impairment losses
    (91 )     (39 )     (52 )     (133.3)  
Gain on sale of loans
    251       34       217       638.2  
Total
  $ 1,337     $ 679     $ 658       96.9 %

 
Noninterest Expense.  Noninterest expense remained relatively unchanged, decreasing $24,000, or 0.8%, to $3.0 million for both quarters ended March 31, 2012 and 2011, respectively.  Salaries and benefits expense decreased by $183,000 for the quarter ended March 31, 2012 compared to the quarter ended March 31, 2011 due to lower payroll costs as we continue to manage our staffing levels.  This reduction in personnel also decreased our medical and retirement costs in the 2012 period compared to the 2011 period.  Operations expense decreased $87,000 during the during the first quarter of 2012 compared to the same period in 2011 as the result of lower third party vendor expense  compared to the same period last year.  This decrease was due to our continuing emphasis on expense control.  Regulatory assessments were $103,000 lower during the 2012 first quarter as compared to the first quarter of last year due to a decrease in FDIC insurance assessments as a result of a decrease in the FDIC’s assessment rate as well as a change in the assessment base calculation.  Losses and expenses on OREO and repossessed assets increased by $330,000 during the first quarter of 2012 compared to the first quarter of 2011 due to higher carrying costs and write downs on OREO properties.
 
A summary of the changes in noninterest expense is presented in the table below:
 
   
Quarter Ended
March 31,
             
   
2012
   
2011
   
Amount
Change
   
Percent
Change
 
   
(Dollar amounts in thousands)
 
Salaries and benefits
  $ 1,283     $ 1,466     $ (183 )     (12.5) %
Operations
    582       669       (87 )     (13.0)  
Regulatory assessments
    122       225       (103 )     (45.8)  
Occupancy
    310       294       16       5.4  
Data processing
    242       239       3       1.3  
Losses and expenses on sale of OREO and repossessed assets
    469       139       330       237.4  
Total
  $ 3,008     $ 3,032     $ (24 )     (0.8) %

 
Income Tax Expense.  For the quarter ended March 31, 2012, we had income tax expense of $245,000 on our pre-tax income as compared to $222,000 for the quarter ended March 31, 2011.  The effective tax rates for the quarters ended March 31, 2012 and 2011 were 31.0% and 30.9%, 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, 2012 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 three months ended March 31, 2012.
 
At March 31, 2012, the Bank had $28.4 million in cash and investment securities available for sale and $1.1 million in loans held for sale generally available for its cash needs.  Also, based on existing collateral pledged, the Bank had the ability to borrow an additional $52.9 million in Federal Home Loan Bank advances, $10.3 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, 2012, outstanding loan commitments, including unused lines and letters of credit totaled $42.1 million.  Certificates of deposit scheduled to mature in one year or less at March 31, 2012, totaled $59.2 million.  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, 2012, the Company, on an unconsolidated basis, had $344,000 in cash, interest-bearing deposits and liquid investments generally available for its cash needs.  The Company’s principal source of liquidity is dividends from the Bank.
 
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.
 
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 September 30, 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 September 30, 2011, is as follows:
 
Off-balance sheet loan commitments
 
(in thousands)
 
Commitments to make loans
  $ 9,740  
Undisbursed portion of loans closed
    4,661  
Unused lines of credit
    27,089  
Irrevocable letters of credit
    578  
Total loan commitments
  $ 42,068  

 
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Capital
 
Sound Community Bank is subject to minimum capital requirements imposed by regulations of the OCC. Based on its capital levels at March 31, 2012, Sound Community Bank exceeded these requirements as of that date. Consistent with our goals to operate a sound and profitable organization, our policy is for Sound Community Bank to maintain a “well-capitalized” status under the regulatory capital categories of the OCC.  Based on capital levels at March 31, 2012, Sound Community Bank was considered to be well-capitalized.  Management monitors the capital levels to provide for current and future business opportunities and to maintain Sound Community Bank’s “well-capitalized” status.
 
The following table shows the capital ratios of Sound Community Bank at March 31, 2012 (dollars in thousands):

   
Actual
   
Minimum Capital
Requirements
   
Minimum Required to
Be Well-Capitalized
Under Prompt
 
   
Amount
   
Ratio
   
Amount
     
Ratio
   
Amount
     
Ratio
 
Tier 1 Capital to total adjusted assets(1)
  $ 28,650       8.24 %   $ 13,910  
    4.00 %     17,388  
    5.00 %
Tier 1 Capital to risk-weighted assets(2)
  $ 28,650       10.87 %   $ 10,542  
    4.00 %(3)     15,812  
    6.00 %
Total Capital to risk-weighted assets(2)
  $ 31,948       12.12 %   $ 21,083  
    8.00 %     26,354  
    10.00 %

(1)
Based on total adjusted assets of $347.8 million.
(2)
Based on risk-weighted assets of $263.5 million.
(3)
The Tier 1 risk-based capital requirement for a well-capitalized institution is 6% of risk-weighted assets.

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, 2012.  There have been no material changes in our market risk since our December 31, 2011 Form 10-K.
 
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, 2012, 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, 2012, 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.
 
 
42

 
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 Control 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, 2012, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
 

 
43

 


 
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              Mine Safety Disclosures

Nothing to report.

Item 5.               Other Information

Nothing to report.

 
44

 

EXHIBIT INDEX
Exhibits:
2.0
Plan of Conversion and Reorganization (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on January 30, 2012 (File No. 000-52889))
3.1
Charter of Sound Financial, Inc. (incorporated herein by reference to the Registration Statement on Form SB-2 filed with the SEC on September 20, 2007 (File No. 333-146196))
3.2
Bylaws of Sound Financial, Inc. (incorporated herein by reference to Pre-Effective Amendment No. 1 to the Registration Statement on Form SB-2 filed with the SEC on September 20, 2007 (File No. 333-146196))
4.0
Form of Common Stock Certificate of Sound Financial, Inc. (incorporated herein by reference to Pre-Effective Amendment No. 1 to the Registration Statement on Form SB-2 filed with the SEC on September 20, 2007 (File No. 333-146196))
10.1
Employment Agreement by and between Sound Community Bank and Laura Lee Stewart (incorporated herein by reference to the Registration Statement on Form SB-2 filed with the SEC on September 20, 2007 (File No. 333-146196))
10.2
Executive Long Term Compensation Agreement effective August 14, 2007 by and between Sound Community Bank and Laura Lee Stewart (incorporated herein by reference to the Registration Statement on Form SB-2 filed with the SEC on September 20, 2007 (File No. 333-146196))
10.3
Amendment to Freeze Benefit Accruals Under the Executive Long Term Compensation Agreement effective August 14, 2007, by and between Sound Community Bank (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on January 5, 2012 (File No. 000-52889))
10.4
Supplemental Executive Long Term Compensation Agreement effective December 31, 2011 by and between Sound Community Bank and Laura Lee Stewart (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on January 5, 2012 (File No. 000-52889))
10.5
Confidentiality, Non-Competition and Non-Solicitation Agreement  by and between Sound Community Bank and Laura Lee Stewart (incorporated herein by reference to the Report on Form 8-K filed with the SEC on January 5, 2012 (File No. 000-52889)) 
10.6
Employment Agreement by and between Sound Community Bank and Matthew Deines (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on November 5, 2009 (File No. 000-52889)) 
10.7
Employment Agreement by and between Sound Community Bank and Matthew Moran (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on November 5, 2009 (File No. 000-52889)) 
10.8
Addendums to the Employment Agreements by and between Sound Community Bank and each of Matthew Deines and Matthew Moran (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on January 3, 2012 (File No. 000-52889)) 
10.9
Summary of Director Board Fee Arrangements (incorporated herein by reference to the Annual Report on Form 10-K filed with the SEC on March 31, 2011 (File No. 000-52889))
10.10
Sound Financial, Inc. 2008 Equity Incentive Plan (incorporated herein by reference to the Annual Report on Form 10-K filed with the SEC on March 31, 2009 (File No. 000-52889))
10.11
Forms of Incentive Stock Option Agreement, Non-Qualified Stock Option Agreement and Restricted Stock Agreements under the 2008 Equity Incentive Plan (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on January 29, 2009 (File No. 000-52889))
10.12
Summary of Annual Bonus Plan (incorporated herein by reference to the Registration Statement on Form SB-2 filed with the SEC on September 20, 2007 (File No. 333-146196))
11
Statement re computation of per share earnings (See Note 8 of the Notes to Condensed Consolidated Financial Statements contained in this Quarterly Report on Form 10-Q.)
31.1
Rule 13(a)-14(a) Certification (Chief Executive Officer)
31.2
Rule 13(a)-14(a) Certification (Chief Financial Officer)
32
Section 1350 Certification
101
Interactive Data Files*
¯         In accordance with Rule 406T of Regulation S-T, these interactive data files are deemed not filed or a part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, are not deemed filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and otherwise are not subject to liability under those section.
 
 

 
45

 

 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.

Date:  May 25, 2012
By:
/s/  Laura Lee Stewart
 
   
Laura Lee Stewart
 
   
President and Chief Executive Officer
 
       
       
       
Date:  May 25, 2012
By:
/s/  Matthew P. Deines
 
   
Matthew P. Deines
 
   
Executive Vice President and Chief Financial Officer