Sound Financial (SNFL) 10-Q 2010 Q1 Quarterly report

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, 2010

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 if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  YES [   ]  NO [X]

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. YES [   ] NO [X]

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 proceeding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes [   ]   No [   ]

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

Large accelerated filer	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 17, 2010, there were issued and outstanding 3,000,095 shares of the registrant’s common stock.

SOUND FINANCIAL, INC.

FORM 10-Q

TABLE OF CONTENTS

	Page Number
PART IFINANCIAL INFORMATION
Item 1.     Financial Statements
Consolidated Balance Sheets as of March 31, 2010 (unaudited) and December 31, 2009	2
Consolidated Statements of Income for the Three Months Ended March 31, 2010 and 2009 (unaudited)	3
Consolidated Statements of Stockholders’ Equity for the Three Months Ended March 31, 2010 (unaudited)	4
Consolidated Statement of Cash Flows For the Three Months Ended March 31, 2010 and 2009 (unaudited)	5
Selected Notes to Consolidated Financial Statements	6
Item 2.    Management's Discussion and Analysis of Financial Condition and Results of Operations	19
Item 3.    Quantitative and Qualitative Disclosures About Market Risk	25
Item 4.    Controls and Procedures	25
PART II   OTHER INFORMATION
Item 1.     Legal Proceedings	26
Item 1A    Risk Factors	26
Item 2.    Unregistered Sales of Equity Securities and Use of Proceeds	26
Item 3.    Defaults Upon Senior Securities	27
Item 4.    Reserved	27
Item 5.    Other Information	27
Item 6.    Exhibits	28
SIGNATURES
EXHIBITS

PART I     FINANCIAL INFORMATION

Item 1       Financial Statements

SOUND FINANCIAL, INC AND SUBSIDIARY
Consolidated Balance Sheets
(unaudited)
	MARCH 31,			DECEMBER 31,
	2010			2009
ASSETS
Cash and cash equivalents	$	5,657,989		$	15,678,766
Securities available-for-sale (AFS), at fair value		12,383,294			9,899,092
Federal Home Loan Bank (FHLB) stock, at cost		2,444,000			2,444,000
Loans held for sale		2,332,901			2,857,700
Loans		297,347,144			289,824,133
Less allowance for loan losses		(4,023,681	)		(3,467,567	)
Total loans, net		293,323,463			286,356,566
Accrued interest receivable		1,337,179			1,305,590
Premises and equipment, net		3,421,615			3,523,753
Bank-owned life insurance		6,528,892			6,462,892
Mortgage servicing rights, at fair value		3,613,924			2,017,489
Mortgage servicing rights, at cost		-			1,309,809
Other real estate owned and repossessed assets		1,904,056			1,383,638
Other assets		4,853,759			4,566,464
Total assets	$	337,801,072		$	337,805,759

LIABILITIES
Deposits
Interest-bearing	$	262,873,142		$	266,337,202
Noninterest-bearing demand		25,058,232			21,226,575
Total deposits		287,931,374			287,563,777
Borrowings		20,000,000			20,000,000
Accrued interest payable		138,247			166,043
Other liabilities		3,891,309			4,668,216
Advance payments from borrowers for taxes and insurance		572,279			339,566
Total liabilities		312,533,209			312,737,602
COMMITMENTS AND CONTINGENCIES (NOTE 4)
STOCKHOLDERS' EQUITY
Preferred stock, $0.01 par value, 1,000,000 shares authorized		-			-
Common stock, $0.01 par value, 24,000,000 shares authorized,      3,000,095 issued and 2,954,295 outstanding as of March 31, 2010      and December 31, 2009		30,001			30,001
Additional paid-in capital		11,720,641			11,687,641
Unearned shares - Employee Stock Ownership Plan (“ESOP”)		(924,480	)		(924,480	)
Retained earnings		15,270,422			15,214,549
Accumulated other comprehensive loss, net of tax		(828,721	)		(939,554	)
Total stockholders’ equity		25,267,863			25,068,157
Total liabilities and stock holders’ equity	$	337,801,072		$	337,805,759

                                  See notes to consolidated financial statements

2

SOUND FINANCIAL, INC. AND SUBSIDIARY

Consolidated Statements of Income

(Unaudited)

	THREE MONTHS ENDED
	MARCH 31,
	2010			2009
INTEREST INCOME
Loans, including fees	$	4,592,243		$	4,354,335
Interest and dividends on investments, cash and cash equivalents		177,312			183,267
Total interest income		4,769,555			4,537,602
INTEREST EXPENSE
Deposits		1,019,512			1,655,966
Other interest expense		148,331			251,707
Total interest expense		1,167,843			1,907,673
NET INTEREST INCOME		3,601,712			2,629,929
PROVISION FOR LOAN LOSSES		1,425,000			450,000
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES		2,176,712			2,179,929
NONINTEREST INCOME
Service charges and fee income		528,528			513,356
Earnings on cash surrender value of bank owned life insurance		66,000			66,000
Mortgage servicing income		164,902			174,918
Fair value adjustment on mortgage servicing rights		285,003			-
Gain on sale of securities		75,018			-
Loss on sale of assets		(48,006	)		(192,864	)
Gain on sale of loans		64,204			23,984
Total noninterest income		1,135,649			585,394
NONINTEREST EXPENSE
Salaries and benefits		1,616,898			1,397,815
Operations		833,588			765,311
Regulatory assessments		230,537			61,619
Occupancy		381,187			270,176
Data processing		200,148			188,773
Total noninterest expense		3,262,358			2,683,694
INCOME  BEFORE PROVISION (BENEFIT)
FOR INCOME TAXES		50,003			81,629
PROVISION (BENEFIT) FOR INCOME TAXES		(7,083	)		6,650
NET INCOME	$	57,086		$	74,979
BASIC EARNINGS PER SHARE	$	0.02		$	0.03
DILUTED EARNINGS PER SHARE	$	0.02		$	0.03

                          See notes to consolidated financial statements

3

SOUND FINANCIAL, INC. AND SUBSIDIARY

Consolidated Statement of Stockholders’ Equity

for the Three Months Ended March 31, 2010 (unaudited)

	Shares		Common Stock		Additional Paid-in Capital		Unearned ESOP Shares			Retained Earnings			Accumulated Other Comprehensive Loss, net of tax			Total Stockholders’ Equity
BALANCE, December 31, 2009		2,954,295	$	30,001	$	11,687,641	$	(924,480	)	$	15,214,549		$	(939,554	)	$	25,068,157
Adoption of fair value option on mortgage servicing rights, net of tax of $13,150											25,527						25,527
Other comprehensive income:
Net income				-		-		-			57,086			-			57,086
Net gain in fair value of investments available for sale, net of tax expense of $57,096														110,834			110,834
Total comprehensive income																	167,920
Cash dividend declared and paid ($0.02 per share)											(26,741	)					(26,741	)
Compensation related to stock options and restricted stock						33,000											33,000
BALANCE, March 31, 2010		2,954,295	$	30,001	$	11,720,641	$	(924,480	)	$	15,270,422		$	(828,721	)	$	25,267,863

See notes to consolidated financial statements

4

SOUND FINANCIAL, INC. AND SUBSIDIARY

Consolidated Statements of Cash Flows (unaudited)

	Three Months Ended March 31,
	2010			2009
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss)	$	57,086		$	74,979
Adjustments to reconcile net income (loss) to net cash from operating activities
Accretion of net premium on investments		(198,744	)		(33,627	)
Gain on sale of securities		75,018			-
Provision for loan losses		1,425,000			450,000
Depreciation and amortization		166,492			113,421
Compensation expense related to stock options and restricted stock		33,000			30,000
Fair value gain on mortgage servicing rights		(285,003	)		-
Additions to mortgage servicing rights		(99,135	)		(211,609	)
Amortization of mortgage servicing rights		136,189			132,533
Increase in cash surrender value of bank owned life insurance		(66,000	)		(66,000	)
Proceeds from sale of loans		9,942,908			21,931,544
Originations of loans held for sale		(9,353,905	)		(25,175,465	)
Loss on sale of other real estate owned and repossessed assets		48,804			25,716
Gain on sale of loans		(64,204	)		(23,984	)
(Decrease) increase in operating assets and liabilities
Accrued interest receivable		(31,589	)		(135,512	)
Other assets		(479,986	)		875,115
Accrued interest payable		(27,796	)		(7,743	)
Other liabilities		(776,907	)		397,540
Net cash from operating activities		501,228			(1,623,092	)
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from maturities and sales of available for sale investments		3,761,671			377,585
Purchase of available for sale investments		(5,831,773	)		(4,936,851	)
Net increase in loans		(9,038,538	)		(2,643,270	)
Improvements to OREO and other repossessed assets		-			(15,345	)
Proceeds from sale of OREO and other repossessed assets		77,420			197,532
Purchases of premises and equipment		(64,354	)		(424,556	)
Net cash from investing activities		(11,095,574	)		(7,444,905	)
CASH FLOWS FROM FINANCING ACTIVITIES
Net increase in deposits, net of acquired deposits		367,597			27,057,585
Proceeds from borrowings		17,100,000			-
Repayment of borrowings		(17,100,000	)		(17,219,355	)
Repurchase of common stock		-			(144,556	)
Cash dividends paid		(26,741	)		(53,065	)
Net change in advances from borrowers for taxes and insurance		232,713			238,342
Net cash from financing activities		573,569			9,878,951
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		(10,020,777	)		810,954
CASH AND CASH EQUIVALENTS, beginning of period		15,678,766			5,607,800
CASH AND CASH EQUIVALENTS, end of period	$	5,657,989		$	6,418,754
SUPPLEMENTAL CASH FLOW INFORMATION
Cash paid for income taxes	$	160,000		$	-
Interest paid on deposits and borrowings	$	1,196,147		$	1,915,416
Net transfer of loans to other real estate owned	$	646,642		$	629,283

See notes to consolidated financial statements

5

SOUND FINANCIAL, INC. AND SUBSIDIARY

Notes to 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 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 generally accepted accounting principles (“GAAP”) for a complete presentation of the Company's financial condition and results of operations.  In the opinion of management, the information reflects all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation of the consolidated financial statements in accordance with GAAP, have been included.  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, 2009, 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 (loss), retained earnings or earnings (loss) per share.

Note 2 – Accounting Pronouncements Recently Issued or Adopted

In April 2010, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2010-18, Receivables (Topic 310): Effect of a Loan Modification When the Loan Is Part of a Pool That Is Accounted for as a Single Asset. This ASU codifies the consensus reached in Emerging Issues Task Force (“EITF”) Issue No. 09-I, “Effect of a Loan Modification When the Loan Is Part of a Pool That Is Accounted for as a Single Asset.” The amendments to the FASB Accounting Standards Codification™ (the “Codification” or “ASC”) provide that modifications of loans that are accounted for within a pool under Subtopic 310-30 do not result in the removal of those loans from the pool even if the modification of those loans would otherwise be considered a troubled debt restructuring. An entity will continue to be required to consider whether the pool of assets in which the loan is included is impaired if expected cash flows for the pool change. ASU 2010-18 does not affect the accounting for loans under the scope of Subtopic 310-30 that are not accounted for within pools. Loans accounted for individually under Subtopic 310-30 continue to be subject to the troubled debt restructuring accounting provisions within Subtopic 310-40.  ASU 2010-18 is effective prospectively for modifications of loans accounted for within pools under Subtopic 310-30 occurring in the first interim or annual period ending on or after July 15, 2010. Early application is permitted. Upon initial adoption of ASU 2010-18, an entity may make a one-time election to terminate accounting for loans as a pool under Subtopic 310-30. This election may be applied on a pool-by-pool basis and does not preclude an entity from applying pool accounting to subsequent acquisitions of loans with credit deterioration. The Company does not expect this ASU to have an impact on our consolidated financial statements.

In April, 2010, the FASB issued ASU No. 2010-13, Compensation—Stock Compensation (Topic 718): Effect of Denominating the Exercise Price of a Share-Based Payment Award in the Currency of the Market in Which the Underlying Equity Security Trades. The ASU codifies the consensus reached in EITF Issue No. 09-J. The amendments to the Codification clarify that an employee share-based payment award with an exercise price denominated in the currency of a market in which a substantial portion of the entity’s equity shares trades should not be considered to contain a condition that is not a market, performance, or service condition. Therefore, an entity would not classify such an award as a liability if it otherwise qualifies as equity. As the Company’s current share-based payment awards are equity awards

6

SOUND FINANCIAL, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements (unaudited)

(exercise price is denominated in dollars in the U.S. where the Company’s stock is traded), this ASU does not have an impact on our consolidated financial statements.

In February 2010, the FASB issued ASU No. 2010-09, Subsequent Events (Topic 855): Amendments to Certain Recognition and Disclosure Requirements. The amendments in this ASU remove the requirement for an SEC filer to disclose a date through which subsequent events have been evaluated in both issued and revised financial statements. Revised financial statements include financial statements revised as a result of either correction of an error or retrospective application of U.S. generally accepted accounting principles. The FASB believes these amendments remove potential conflicts with the SEC’s literature. All of the amendments in the ASU were effective upon issuance.

In January 2010, the FASB issued ASU No. 2010-06, Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements. This ASU requires: (1) disclosure of the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurement categories and the reasons for the transfers; and (2) separate presentation of purchases, sales, issuances, and settlements in the reconciliation for fair value measurements using significant unobservable inputs (Level 3). In addition, ASU 2010-06 clarifies the requirements of the following existing disclosures set forth in the Codification Subtopic 820-10: (1) For purposes of reporting fair value measurement for each class of assets and liabilities, a reporting entity needs to use judgment in determining the appropriate classes of assets and liabilities; and (2) a reporting entity should provide disclosures about the valuation techniques and inputs used to measure fair value for both recurring and non-recurring fair value measurements. ASU 2010-06 is effective for interim and annual reporting periods beginning January 1, 2010, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements, which are effective for fiscal years beginning January 1, 2011, and for interim periods within those fiscal years. As ASU 2010-06 is disclosure-related only, our adoption of this ASU in the first quarter of 2010 did not impact our consolidated financial statements.

Note 3 – Fair Value Measurements

Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.  

It also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.  The standard describes three levels of inputs that may be used to measure fair value:

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active exchange markets that the entity has the ability to access as of the measurement date.

Level 2: Significant other observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active and other inputs that are observable or can be corroborated by observable market data.

Level 3: Significant unobservable inputs that reflect a company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

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SOUND FINANCIAL, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements (unaudited)

In determining the appropriate levels, the Company performs a detailed analysis of the assets and liabilities that are subject to fair value measurements.  In certain cases, the inputs used to measure fair value of an asset or liability may fall into different levels of the fair value hierarchy.  The level within which the fair value measurement is categorized is based on the lowest level input that is significant to the fair value measurement in its entirety.  Therefore, an item may be classified in Level 3 even though there may be some significant inputs that are readily observable.

Valuation Methodologies

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

Mortgage Servicing Rights - The fair value of purchased mortgage servicing rights is estimated using a discounted cash flow model based on market information from a third party. These assets are classified as Level 3.  At March 31, 2010, mortgage servicing rights are carried at fair value.

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 or based on discounted cash flow models. Level 1 securities include those traded on an active exchange, as well as U.S. government and its agencies securities. Level 2 securities include mortgage-backed securities and certain collateralized mortgage obligations (CMOs).

Loans Held for Sale - Residential mortgage loans held for sale are recorded at the lower of cost or fair value. The fair value of fixed-rate residential loans is based on whole loan forward prices obtained from government sponsored enterprises. These loans are classified as Level 2 and are measured on a nonrecurring basis.  At March 31, 2010, loans held for sale were carried at cost.

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

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.  Any write-downs based on the asset’s fair value at the date of acquisition are charged to the allowance for loan losses. After foreclosure, management periodically performs valuations such that the real estate is carried at the lower of its new cost basis or fair value, net of estimated costs to sell.  These assets are classified as level 3.

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SOUND FINANCIAL, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements (unaudited)

The following table presents the balances of assets measured at fair value on a recurring basis at March 31, 2010:

	Fair Value at March 31, 2010
Description	Total		Level 1		Level 2		Level 3
Mortgage Servicing Rights	$	3,613,924	$	-	$	-	$	3,613,924
Agency mortgage-backed securities		7,500,793		-		7,500,793	$	-
Non-agency mortgage-backed securities		4,882,501		-		4,882,501	$	-
Total	$	15,997,218	$	-	$	12,383,294	$	3,613,924

The following table presents the balance of assets measured at fair value on a nonrecurring basis at March 31, 2010, and the total losses resulting from these fair value adjustments for the three months ended March 31, 2010:

	Fair Value at March 31, 2010								Three Months Ended March 31, 2010
	Total		Level 1		Level 2		Level 3		Total Losses
Description
Loans Held for Sale	$	2,332,901		-	$	2,332,901	$	-	$	-
OREO and Repossessed Assets		1,904,056		-		-		1,904,056		48,006
Impaired Loans		13,228,703		-		-		13,228,703		890,765
Total	$	17,465,660		-	$	2,332,901	$	15,132,759	$	938,771

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

The following methods and assumptions were used to estimate fair value of each class of financial instruments listed below:

Cash and cash equivalents, accrued interest receivable and payable, and advance payments from borrowers for taxes and insurance - The estimated fair value is equal to the carrying amount.

 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 or based on discounted cash flow models. Level 1 securities include those traded on an active exchange, as well as U.S. government and its agencies securities. Level 2 securities include mortgage-backed securities and certain collateralized mortgage obligations (CMOs).

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

Loans Held for Sale - Residential mortgage loans held for sale are recorded at the lower of cost or fair value. The fair value of fixed-rate residential loans is based on whole loan forward prices obtained from government sponsored enterprises. These loans are classified as Level 2 and are measured on a nonrecurring basis.  At March 31, 2010, loans held for sale were carried at cost.

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SOUND FINANCIAL, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements (unaudited)

 Mortgage Servicing Rights - The fair value of purchased mortgage servicing rights is estimated using a discounted cash flow model based on market information from a third party. These assets are classified as Level 3.  At March 31, 2010, mortgage servicing rights are carried at fair value.

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

Bank-owned Life Insurance - The estimated fair value is equal to the outstanding book value of policies.

Deposits - The estimated fair value of deposit accounts (savings, demand deposit, and money market accounts) is the carrying amount. The fair value of fixed-maturity time certificates of deposit are estimated by discounting the estimated cash flows using the current rate at which similar certificates would be issued.

Borrowings - The fair value of FHLB advances are estimated using discounted cash flow analyses, based on the Bank’s current incremental borrowing rates for similar types of borrowing arrangements.

Off-balance-sheet financial instruments - The fair value for the Bank’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 Bank’s customers. The estimated fair value of these commitments is not significant.

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

	March 31, 2010				December 31, 2009
	Carrying		Fair		Carrying		Fair
	Amount		Value		Amount		Value
Financial assets:
Cash and cash equivalents	$	5,657,989	$	5,657,989	$	15,678,766	$	15,678,766
AFS securities		12,383,294		12,383,294		9,899,092		9,899,092
FHLB stock		2,444,000		2,444,000		2,444,000		2,444,000
Loans held for sale		2,332,901		2,332,901		2,857,700		2,857,700
Loans, net		293,323,463		294,146,214		286,356,566		286,430,669
Accrued interest receivable		1,337,179		1,337,179		1,305,590		1,305,590
Bank-owned life insurance		6,528,892		6,528,892		6,462,892		6,462,892
Mortgage servicing rights, fair value		3,613,924		3,613,924		2,017,489		2,017,489
Mortgage servicing rights, at cost		-		-		1,309,809		1,360,417
Financial liabilities:
Demand deposits	$	153,651,401	$	153,651,401	$	151,675,433	$	151,675,433
Time deposits		134,279,973		136,913,380		135,888,344		137,833,241
Borrowings		20,000,000		19,842,672		20,000,000		19,735,005
Accrued interest payable		138,247		138,247		166,043		166,043
Advance payments from
borrowers for taxes and insurance		572,279		572,279		339,566		339,566

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

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SOUND FINANCIAL, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements (unaudited)

rate levels change, which may be favorable or unfavorable to us. Management attempts to match maturities of assets and liabilities to the extent necessary or possible to minimize interest rate risk.

However, borrowers with fixed-rate obligations are less likely to prepay in a rising rate environment and more likely to prepay in a falling rate environment. Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment. Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by establishing early withdrawal penalties for certificates of deposit, creating interest rate floors for certain variable rate loans, adjusting terms of new loans and deposits, by borrowing at fixed rates for fixed terms and investing in securities with terms that mitigate our overall interest rate risk.

Note 4 – Commitments and Contingencies

In the normal course of operations, the Bank 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.

Note 5 - Legal Proceedings

In November 2007, Visa Inc. (“Visa”) announced that it had reached a settlement with American Express and Discover Card related to antitrust lawsuits. The Company and other Visa member banks were obligated to fund the settlement and share in losses resulting from this litigation.  The Company is not a party to the Visa litigation and its liability arises solely from the Company’s membership interest in Visa, Inc.

In the first quarter of 2008, Visa completed an initial public offering and the Company received $154,000 as part of a subsequent mandatory partial redemption of our Visa Class B shares.  Using the proceeds from this offering, Visa established a $3.0 billion escrow account to cover settlements, the resolution of pending litigation and related claims (“covered litigation”).

As of March 31, 2010, the Company owned 5,699 shares of Class B common stock.  These shares are restricted and may not be transferred until the later of (i) three years from the date of the initial public offering or (ii) the period of time necessary to resolve the covered litigation.  A conversion ratio of 0.71429 was initially established for the conversion rate of Class B shares into Class A shares.  If the funds in the escrow account are insufficient to settle all the covered litigation, Visa may sell additional Class A shares, use the proceeds to settle litigation, and further reduce the conversion ratio.  If funds remain in the escrow account after all litigation is settled, the Class B conversion ratio will be increased to reflect that surplus.  In December 2008, Visa deposited additional funds into the escrow account to satisfy a settlement with Discover Card related to and antitrust lawsuit.  In July 2009, Visa deposited additional funds into the litigation escrow account to provide additional reserves to cover potential losses related to the two remaining litigation cases.  This deposit reduced the conversion ratio applicable to Class B shares outstanding from 0.71429 to 0.5824 per Class A share.

As of March 31, 2010, the value of the Class A shares was $91.03 per share.  Using the new conversion ratio, the value of unredeemed Class A equivalent shares owned by the Company was $302,000, and has not been reflected in the accompanying financial statements.

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SOUND FINANCIAL, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements (unaudited)

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.

Note 6 – Loans

The composition of the loan portfolio, excluding loans held for sale, was as follows:

	March 31 2010			December 31, 2009			Percentage Increase/ (Decrease)
Real estate loans
One- to four-family	$	104,895,376		$	104,460,367			0.4	%
Home equity		49,006,769			50,444,530			(2.9	%)
Commercial		82,411,578			72,035,266			14.4	%
Construction or development		9,313,351			10,000,289			(6.9	%)
		245,627,074			236,940,452			3.7	%
Consumer loans
Manufactured homes		20,802,939			21,472,799			(3.1	%)
Automobile		5,683,341			6,445,829			(11.8	%)
Other		8,584,480			7,499,180			14.5	%
		35,070,760			35,417,808			(1.0	%)
Commercial business loans		17,087,419			17,799,946			(4.0	%)
Total loans		297,785,253			290,158,206			2.6	%
Deferred loan origination fees		(438,109	)		(334,073	)		31.1	%
Allowance for loan losses		(4,023,681	)		(3,467,567	)		16.0	%
Total loans, net	$	293,323,463		$	286,356,566			2.4	%

The following is an analysis of the change in the allowance for loan losses:

	Three Months Ended March 31,
	2010			2009
Balance, beginning of year	$	3,467,567		$	1,305,950
Provision for loan losses		1,425,000			450,000
Recoveries		21,879			27,293
Charge-offs		(890,765	)		(310,909	)
Balance, end of year	$	4,023,681		$	1,472,334

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SOUND FINANCIAL, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements (unaudited)

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

	March 31			December 31,
	2010			2009
Impaired loans with a valuation allowance	$	10,018,124		$	4,125,169
Valuation allowance related to impaired loans		(1,442,012	)		(1,424,270	)
Impaired loans without a valuation allowance		3,210,579			9,019,027
Total impaired loans, net of valuation allowance for impaired loans	$	11,786,691		$	11,719,926
Total non-accrual loans		3,515,000			3,607,000
Average investment in impaired loans		3,448,000			11,385,000
Forgone interest on non-accrual loans		62,000			203,000
Interest income recognized on impaired loans		110,000			-
Troubled debt restructured loans		9,874,000			7,424,000

At March 31, 2010, there were no commitments to lend additional funds to borrowers whose loans were classified as non-accrual or impaired.  At March 31, 2010 and December 31, 2009 there were no loans past due 90 days or more and still accruing interest.

Note 7 – Investments

The amortized cost and fair value of our AFS securities and the corresponding amounts of gross unrealized gains and losses were as follows:

			Gross Unrealized
	Amortized Cost		Gains		Losses 1 Year or Less			Losses Greater Than 1 Year			Estimated Fair Value
March 31, 2010
Agency mortgage-backed securities	$	7,464,288	$	47,095	$	(10,590	)	$	-		$	7,500,793
Non-agency mortgage-backed securities		6,113,421		-		-			(1,230,920	)		4,882,501
Total	$	13,577,709	$	47,095	$	(10,590	)	$	(1,230,920	)	$	12,383,294
December 31, 2009
Agency mortgage-backed securities	$	3,421,392	$	5,415	$	(57,076	)	$	-		$	3,369,731
Non-agency mortgage-backed securities		7,901,268		120,866		-			(1,492,273	)		6,529,361
Total	$	11,322,660	$	126,281	$	(57,076	)	$	(1,492,773	)	$	9,899,092

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SOUND FINANCIAL, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements (unaudited)

The amortized cost and fair value of mortgage-backed securities by contractual maturity, at March 31, 2010, 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, 2010
	Amortized Cost		Fair Value
Due within one year	$	-	$	-
Due after one year through five years		-		-
Due after five years through ten years		-		-
Due after ten years		13,577,709		12,383,294
	$	13,577,709	$	12,383,294

Securities with an amortized cost and fair value of $2.2 million at March 31, 2010 were pledged to secure Washington State Public Funds.

Other-Than-Temporary-Impairment

We review investment securities on an ongoing basis for the presence of other-than-temporary (“OTTI”) or permanent impairment, taking into consideration current market conditions, fair value in relationship to cost, extent and nature of the change in fair value, issuer rating changes and trends, whether we intend to sell a security or if it is likely that we will be required to sell the security before recovery of our amortized cost basis of the investment, which may be maturity, and other factors.  For debt securities, if we intend to sell the security or it is likely that we will be required to sell the security before recovering its cost basis, the entire impairment loss would be recognized in earnings as an OTTI.

If we do not intend to sell the security and it is not likely that we will be required to sell the security but we do not expect to recover the entire amortized cost basis of the security, only the portion of the impairment loss representing credit losses would be recognized in earnings.  The credit loss on a security is measured as the difference between the amortized cost basis and the present value of the cash flows expected to be collected.

Projected cash flows are discounted by the original or current effective interest rate depending on the nature of the security being measured for potential OTTI.  The remaining impairment related to all other factors, the difference between the present value of the cash flows expected to be collected and the fair value, is recognized as a charge to other comprehensive income (“OCI”).  Impairment losses related to all other factors are presented as separate categories within OCI.

As of March 31, 2010, our securities portfolio consisted of non-agency mortgage backed securities with a fair value of $12.4 million, of which, $7.9 million, or eight securities, were in an unrealized loss position.  The unrealized losses on U.S. agency securities were caused by interest rate increases subsequent to the purchase of these securities.  The unrealized losses on non-U.S. agency securities 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. Because the Bank does not intend to sell the securities and it is not likely that the Bank will be required to sell these securities before recovery of the amortized cost basis, which may include holding each security until contractual maturity, the unrealized losses on these investments are not considered other-than-temporarily impaired.

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SOUND FINANCIAL, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements (unaudited)

Note 8 – Mortgage Servicing Rights

On January 1, 2010, the Company elected to adopt ASC 860-50-50-3 Servicing Assets and Liabilities, for all mortgage servicing rights using the fair value measurement method. Management believes that this method better represents the ongoing market value of the servicing asset.  In addition to this factor, the Company was previously carrying its acquired mortgage servicing rights portfolio at market value and management believes that it will be more consistent to report all mortgage servicing assets under the same method.

The changes in the mortgage servicing asset is summarized below:

Beginning balance as of January 1, 2010	$	3,327,298
Adoption of fair value option on mortgage servicing rights		38,677
Fair Value as of January 1, 2010		3,365,975
Additions:
Servicing obligations that result from transfers of financial assets		99,135
Subtractions:
Disposals of servicing obligations		(136,189	)
Other changes in Fair Value		285,003
Fair Value as of March 31, 2010	$	3,613,924

Note 9 – Borrowings

The Company utilizes a loan agreement with the FHLB of Seattle. The terms of the agreement call for a blanket pledge of a portion of the Company’s mortgage and commercial real estate portfolio based on the outstanding balance. At March 31, 2010, the amount available to borrow under this agreement is approximately 35% of total assets, or up to $118.2 million subject to the availability of eligible collateral. The Company had outstanding borrowings under this arrangement of $20.0 million at March 31, 2010 and December 31, 2009.

The Company participates in the Federal Reserve Bank’s Borrower-in-Custody program, which gives the Company access to the discount window.  The terms of the program call for a pledge of specific assets.  The Company had unused borrowing capacity of $19.0 million and $17.0 million at March 31, 2010 and December 31, 2009, respectively.  There were no outstanding borrowings at March 31, 2010 or December 31, 2009.

The Company has access to an unsecured line of credit from the Pacific Coast Banker’s Bank.  This line of credit is equal to $2.0 million as of March 31, 2010.  The line has a one-year term and is renewable.  There was no outstanding balance on this line of credit as of March 31, 2010 and December 31, 2009.

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SOUND FINANCIAL, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements (unaudited)

Note 10 – Earnings (loss) Per Share

Earnings (loss) per share are summarized in the following table:

	Three months ended March 31,
	2010		2009
Net income (loss)	$	57,086	$	74,979
Weighted average number of shares outstanding, basic		2,909,072		2,894,540
Effect of dilutive stock options		-		-
Weighted average number of shares outstanding, diluted		2,909,072		2,894,540
Earnings per share, basic	$	0.02	$	0.03
Earnings per share, diluted	$	0.02	$	0.03

For the three month period ended March 31, 2009, there were no non-dilutive securities included in the calculation for earnings per share.

Note 11 – Stock-based Compensation

Stock Options and Restricted Stock

In 2008, the board of directors adopted and shareholders approved an Equity Incentive Plan (the “Plan”).  The Plan was approved by shareholders at the special meeting of shareholders held on November 19, 2008.  The plan permits the grant of restricted stock and stock options. Under the Plan 144,455 shares of common stock were approved for stock options and stock appreciation right and 57,782 shares of common stock were approved for restricted stock and restricted stock units.

On January 27, 2009, the Compensation Committee of the Board of Directors of the Company awarded shares of restricted stock and stock options to directors, executive officers and employees of the Company, and its wholly owned subsidiary, Sound Community Bank, pursuant to the Plan. The Company granted 25,998 non-qualified stock options and 82,400 incentive stock options to certain directors and employees.  The Company also granted 52,032 shares of restricted stock to certain directors and employees. During the period ended March 31, 2010, share based compensation expense totaled $33,000.

All of the awards vest in 20 percent annual increments over the next five years. The options are exercisable for a period of 10 years from the date of grant, subject to vesting. Half of the stock options granted to each of the individuals indicated above were at an exercise price of $7.35, which was the fair market value of the Company’s common stock on the grant date. The remaining half of the stock options granted to each of the individuals indicated above were at an exercise price of $8.50, which was $1.15 above the fair market value of the Company’s common stock on the grant date. The vesting date for options and restricted stock is accelerated in the event of the grantee’s death, disability or a change in control of the Company.

There were 21,680 exercisable stock options as of March 31, 2010. The aggregate intrinsic value of the stock options as of March 31, 2010 was $0.

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SOUND FINANCIAL, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements (unaudited)

The following is a summary of the Company’s stock option plan awards during the period ended March 31, 2010:

	Shares		Weighted-Average Exercise Price		Weighted-Average Remaining Contractual Term In Years		Aggregate Intrinsic Value
Outstanding at the beginning of the year		108,398	$	7.93
Granted		-		-
Exercised		-		-
Forfeited or expired		-		-
Outstanding at March 31, 2010		108,398	$	7.93		8.84	$	-
Expected to vest, assuming a 0% forfeiture rate over the vesting term		108,398	$	7.93		8.84	$	-

As of March 31, 2010, there was $213,000 of total unrecognized compensation cost related to nonvested stock options granted under the Plan.  The cost is expected to be recognized over the remaining weighted-average vesting period of 3.84 years.

Restricted Stock Awards

The fair value of the restricted stock awards is equal to the fair value of the Company’s stock at the date of grant. Compensation expense is recognized over the vesting period that the awards are based. Shares awarded as restricted stock vest ratably over a five-year period beginning at the grant date with 20% vesting on the anniversary date of each grant date. 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. As of March 31, 2010, 45,800 shares have been repurchased under the Plan.

The following is a summary of the Company’s nonvested restricted stock awards for the period ended March 31, 2010:

Nonvested Shares	Shares		Weighted-Average Grant-Date Fair Value		Aggregate Intrinsic Value
Nonvested at January 1, 2010		52,032	$	7.35
Granted		-		-
Vested		10,406		-
Forfeited		-		-
Nonvested at March 31, 2009		41,626	$	7.35	$	4.50
						-
Expected to vest assuming a 0% forfeiture rate over the vesting term		41,626	$	7.35	$	4.50

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SOUND FINANCIAL, INC. AND SUBSIDIARY.

Notes to Consolidated Financial Statements (unaudited)

            The aggregate intrinsic value of the restricted stock options as of March 31, 2010 was $187,000.

As of March 31, 2010, $294,000 of unrecognized compensation cost related to non-vested restricted stock granted under Plan remained.  The cost is expected to be recognized over the weighted-average vesting period of 3.84 years.

Employee Stock Ownership Plan

In January 2008, the ESOP borrowed $1,155,600 from the Company to purchase common stock of the Company. The loan is being repaid principally from the Company’s contributions to the ESOP over a period of ten years. The interest rate on the loan is fixed at 4.0% per annum.  As of March 31, 2010, the remaining balance of the ESOP loan was $962,000.  Neither the loan nor the related interest is reflected on the consolidated financial statements.

At March 31, 2010, 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 $416,000 at March 31, 2010.  ESOP compensation expense included in salaries and benefits was $17,000 for the period ended March 31, 2010.

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

Forward-Looking Statements

This Form 10-Q contains various forward-looking statements that are based on assumptions and describe our future plans and strategies and our expectations.  These forward-looking statements are generally identified by words such as “believe,” “expect,” “intend,” “anticipate,” “estimate,” “project,” or similar words.  Our ability to predict results or the actual effect of future plans or strategies is uncertain.  Factors which could cause actual results to differ materially from those estimated include, but are not limited to, changes in interest rates, general economic conditions, legislative/regulatory changes, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality and composition of our loan and investment portfolios, demand for our loan products, deposit flows, our operating expenses, competition, demand for financial services in our market areas and accounting principles and guidelines.  These risks and uncertainties should be considered in evaluating forward-looking statements, and you should not rely too much on these statements.  We do not undertake, and specifically disclaim, any obligation to publicly revise 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.

General

Sound Financial, Inc. is a federally chartered stock holding Company and is subject to regulation by the Office of Thrift Supervision (“OTS”).  Sound Financial, Inc. was organized 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, Inc., which owns 100% of the common stock of Sound Community Bank; and (iii) organized Sound MHC, which currently owns 54% of the common stock of Sound Financial, Inc.  Sound MHC has no other activities or operations other than its ownership of Sound Financial, Inc.  Sound Community Bank succeeded to the business and operations of the Company in its mutual form and Sound Financial, Inc. has no significant assets other than all of the outstanding shares of common stock of Sound Community Bank, its loan to the Sound Financial, Inc.’s Employee Stock Ownership Plan, and certain liquid assets.

Unless the context otherwise requires, references in this document to the “Company” or “Sound Financial” refer to Sound Financial, Inc. and references to the “Bank” refer to Sound Community Bank (in its stock or mutual form).  References to “we,” “us,” and “our” means Sound Financial, Inc. or Sound Community Bank, unless the context otherwise requires.

In connection with the above-mentioned reorganization, Sound Financial sold 1,297,148 shares of common stock in a subscription offering that closed on January 8, 2008.  Those shares constitute 44% of the outstanding shares of common stock of Sound Financial.  Sound Financial also issued 29,480 shares of common stock to Sound Community Foundation, a charitable foundation created by Sound Community Bank in connection with the mutual holding Company reorganization and subscription offering.  The remaining 1,621,435 shares of common stock of Sound Financial outstanding were issued in accordance with federal law to Sound Community MHC, a federal mutual holding Company (“MHC”).

Substantially all of Sound Financial’s business is conducted through the Bank, which is a federal savings bank subject to extensive regulation by the OTS.  Sound Community Bank’s deposits are insured up to applicable limits by the Federal Deposit Insurance Corporation (“FDIC”).  At March 31, 2010, we had total consolidated assets of $337.8 million, deposits of $287.9 million and stockholders’ equity of $25.3 million.  The shares of Sound Financial are traded on the Over-the-Counter Electronic Bulletin

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Board under the symbol “SNFL.”  Our executive offices are located at 2005 5th Avenue – Suite 200, Seattle, Washington, 98121.

Sound Community Bank was originally chartered in 1953 as the Associated Grocers Employees Federal Credit Union.  By the late 1980’s, the members of the credit union expanded from employees of Associated Grocers to employees of other businesses.  In the 1990’s, the credit union was serving employees of approximately 450 small companies.  In 1992, it changed its name to Credit Union of the Pacific.  On May 19, 2003, Credit Union of the Pacific converted its charter from a state-chartered credit union to a federally chartered savings bank.  On that date the name was changed from Credit Union of the Pacific to Sound Community Bank, and the Company became a taxable organization.

The Company’s principal business consists of attracting retail and small business 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 real estate, consumer and commercial business loans and, to a lesser extent, construction and development 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.  We intend to continue emphasizing our residential mortgage, home equity and consumer lending, while also expanding our emphasis in commercial real estate and commercial business lending.  In recent years, we have focused on expanding our commercial loan portfolio (commercial real estate and other commercial loans), which has grown to $101.7 million or 34.2% of our loan portfolio at March 31, 2010, from $77.2 million or 28.1% of our loan portfolio at March 31, 2009.

As part of our business, we focus on 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 support our emphasis on strong customer service.  We originated $16.0 million and $25.2 million in one- to four-family residential mortgage loans during the three month periods ended March 31, 2010 and 2009, respectively.  During these same periods, we sold $9.8 million and $22.0 million, respectively, of one- to four-family residential mortgage loans.

We offer a variety of deposit accounts, which are our primary source of funding for our lending activities.  In recent years we have also relied on Federal Home Loan Bank advances to augment our deposits and fund the growth of interest earning assets.

The Company’s earnings are primarily dependent upon our net interest income, the difference between interest income and interest expense.  Interest income is a function of the balances of loans and investments outstanding during a given period and the yield earned on these loans and investments.  Interest expense is a function of the amount of deposits and borrowings outstanding during the same period and interest rates paid on these deposits and borrowings.  The Company’s earnings are also affected by our provision for loan losses, service charges and fees, gains and losses from sales of loans, investments and other assets, other income, operating expenses and income taxes.

During 2009, the Company expanded its operations through the acquisition of two branches in Port Angeles and Tacoma, Washington.  In July 2009, the Company opened a new branch in Port Angeles.  On September 1, 2009, the Company acquired the Port Angeles and Tacoma offices of 1st Security Bank, including $33.6 million in deposits.  The operations of the Port Angeles location were moved to the Company’s new Port Angeles branch, and the 1st Security Bank branch location was vacated.  The Company’s former branch in Lakewood was closed and the operations were consolidated with the leased 1st Security branch in Tacoma.  On March 31, 2010, the Company’s branch in Tukwila was closed and the operations were consolidated with the downtown Seattle branch.

20

Critical Accounting Policies

We consider accounting policies involving significant judgments and assumptions by management that have, or could have, a material impact on the carrying value of certain assets or on income to be critical accounting policies. We consider our critical accounting policies to be those related to our allowance for loan losses, mortgage serving rights, other real estate owned, and deferred tax asset accounts.  The allowance for loan losses is maintained to cover losses that are probable and can be estimated on the date of the evaluation in accordance with U.S. generally accepted accounting principles.  It is management’s best estimate of probable incurred credit losses in our loan portfolio.  Our methodologies for analyzing the allowance for loan losses, mortgage serving rights, other real estate owned and deferred tax asset accounts are described in our Form 10-K Annual Report for the year ended December 31, 2009.

Comparison of Financial Condition at March 31, 2010 and December 31, 2009

General.  Total assets decreased by $5,000 in the period to $337.8 million at March 31, 2010.  The limited overall change was primarily the result of a $10.0 million, or 63.9%, decrease in cash and cash equivalents which was offset by a $7.0 million increase in our loan portfolio, including loans held for sale, from $286.4 million at December 31, 2009 to $293.3 million at March 31, 2010 and the purchase of agency mortgage-backed securities, which increased by $2.5 million or 20.1%, from $9.9 million at December 31, 2009 to $12.4 million at March 31, 2010.

Loans.  Our loan portfolio increased $7.0 million, or 2.4%, to $293.3 million at March 31, 2010, from $286.4 million at December 31, 2009.  The changes in our net loan portfolio are reflected in Note 6 to our financial statements above.  The most significant changes include a 14.4% increase in commercial real estate loans, a 14.5% increase in other consumer loans and an 11.8% decrease in auto loans.  The increase in commercial real estate loans during the three months ended March 31, 2010 is consistent with our strategy to diversify our loan portfolio and increase the amount of generally higher-yielding commercial loans in our portfolio.  The increase in other consumer loans is primarily a result of a houseboat loan closed in the first quarter.  The decrease in auto loan demand is primarily a result of the general state of the economy which is negatively impacting auto sales coupled with aggressively subsidized rates currently offered by auto manufacturers.

           Allowance for Loan Losses.  Our allowance for loan losses at March 31, 2010, was $4.0 million, or 1.37%, of net loans receivable, compared to $3.5 million, or 1.21%, of net loans receivable at December 31, 2009.  The increase in the allowance for loan losses was the result of a $1,425,000 provision for loan losses recorded during the three months ended March 31, 2010, partially offset by net charge-offs of non-performing loans totaling $891,000.  This provision was primarily made as a result of increases in our commercial loan portfolio in the 2010 period, as compared to the 2009 period, an increase in our specifically impaired loans and an evaluation of prevailing housing and other market conditions.  Non-performing loans decreased to $3.5 million at March 31, 2010, from $3.6 million at December 31, 2009.  Non-performing loans to total loans decreased to 1.18% at March 31, 2010, from 1.25% at December 31, 2009.  Other real estate owned increased by $520,000, or 37.6% to $1.9 million at March 31, 2010, compared to $1.4 million as of December 31, 2009.  This increase is a result of five additional properties taken back by the Bank in the quarter and the sale of three previously held properties.  The Company believes that higher non-performing assets and charge-offs will continue going forward until the housing market and general market conditions begin to recover.

Cash, Cash Equivalents and Securities.  Cash and cash equivalents decreased by $10.0 million, or 63.9%, to $5.7 million at March 31, 2010.  Our securities portfolio consists of mortgage-backed securities, all of which are designated as available-for-sale and FHLB stock, which is carried at cost.  The securities portfolio increased by $2.5 million, or 20.1%, to $12.4 million at March 31, 2010 from $9.9 million at December 31, 2009.  This increase reflects the purchase of agency mortgage-backed securities.

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Included in our investment portfolio are $4.9 million in non-agency mortgage-backed securities.  These securities present a level of credit risk that does not exist currently with agency backed securities which are guaranteed by the United States government. In order to monitor the risk of these securities, management receives a credit surveillance report which considers various factors for each security including original credit scores, loan to value, geography, delinquency and loss history.  The report also evaluates the underlying loans within the security to project future losses based on various home price depreciation scenarios over a three year horizon.  Based on this analysis, management does not expect to incur any principal loss on any of these investments as of March 31, 2010.

Deposits.  Total deposits increased by $368,000, or 0.13%, to $287.9 million at March 31, 2010, from $287.6 million at December 31, 2009.  Decreases in time deposits, money market accounts, and interest-bearing and noninterest-bearing checking accounts were offset by increases in savings and escrow accounts.  The $3.3 million or 333.0% increase in escrow accounts were primarily a result of the purchase of a servicing portfolio from Leader financial in the fourth quarter of 2009. The decrease in time deposits and other interest-bearing accounts reflects a bank-wide emphasis to generate additional low-cost deposits.

Borrowings.  Federal Home Loan Bank advances remained constant at $20.0 million at March 31, 2010.  The weighted average cost of borrowings as of March 31, 2010 was 2.87%, compared to our weighted average cost of deposits was 1.34% at that date.

Equity.  Total equity increased $200,000, or 0.80%, to $25.3 million at March 31, 2010, from $25.1 million at December 31, 2009.  This reflects a $111,000 decrease in accumulated other comprehensive loss, $58,000 in earnings, $33,000 in stock compensation expense, $27,000 in dividends and a $26,000 adjustment to equity due to the adoption of fair value accounting for mortgage servicing rights.

Comparison of Results of Operation for the Three Months Ended March 31, 2010 and 2009

General.  Net income decreased $18,000 to $57,000 for the three months ended March 31, 2010, compared to $75,000 for the three months ended March 31, 2009.  Higher interest and non-interest income and lower interest expense was offset by increases in the provision for loan losses and higher non-interest expense.

Interest Income.  Interest income increased by $232,000, or 5.1 %, to $4.8 million for the three months ended March 31, 2009 from $4.5 million for the three months ended March 31, 2009.  The increase in interest income for the period reflects higher overall loan balances, particularly an increase in the amount of commercial loans at generally higher rates.

The weighted average yield on loans decreased to 6.28% for the three months ended March 31, 2010, from 6.33% for the three months ended March 31, 2009.  The decrease was primarily the result of overall decreases in the rate environment, which include record lows in the prime interest rate and the 1-year Treasury bill rate, which we use to set and adjust rates for certain variable rate loans.  We anticipate our weighted average yield on loans will improve as we continue to emphasize higher yielding commercial real estate and business loans. However, this improvement will also depend on the overall rate environment and our ability to manage credit risk.

Interest Expense.  Interest expense decreased $740,000, or 38.8%, to $1.2 million for the three months ended March 31, 2009, from $1.9 million for the three months ended March 31, 2009.  The decrease for the period resulted primarily from the lower interest rates paid on repricing deposits and FHLB advances as a result of the continued low interest rate environment.  Our weighted average cost of interest-bearing liabilities was 1.63% for the three months ended March 31, 2010, compared to 2.86% for the same period in 2009.

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Interest paid on deposits decreased $636,000, or 38.4%, to $1.0 million for the three months ended March 31, 2010, as compared to $1.7 million for the three months ended March 31, 2009.  The decrease for the three month period resulted primarily from a decrease in the weighted average cost of deposits. We experienced a 134 basis point decrease in the average rate paid on deposits during the three months ended March 31, 2010, compared to the same period in 2009, from 2.77% to 1.43%, respectively.  This decrease in average rates was a result of the repricing of matured certificates of deposit that the Bank was able to retain at significantly lower rates as well as lower interest rates paid on savings and money market accounts.

Interest expense on borrowings decreased $103,000, or 41.1%, to $148,000 for the three months ended March 31, 2010 from $252,000 for the three months ended March 31, 2009.  The decrease resulted from a decrease in the average balance of outstanding borrowings of $6.8 million, to $20.7 million for the three months ended March 31, 2010, from $27.5 million for the three months ended March 31, 2009 coupled with a lower weighted average cost of borrowings during the 2010 period.

Net Interest Income.  Net interest income increased $972,000, or 37.0%, to $3.6 million for the three months ended March 31, 2010, from $2.6 million for the three months ended March 31, 2009.  The increase in net interest income for the three-month period primarily resulted from higher yields earned on our expanding commercial loan portfolio and decreased interest expense on deposits and borrowings as a result of the falling interest rate environment.  Our net interest margin was 4.65% for the three months ended March 31, 2010,which is an increase from the 3.75% for the three months ended March 31, 2009.

Provision for Loan Losses.  We establish provisions for loan losses, which are charged to earnings, at a level required to reflect management’s best estimate of the probable incurred credit losses in the loan portfolio.  In evaluating the level of the allowance for loan losses, management considers historical loss experience, the types of loans and the amount of loans in the loan portfolio, adverse situations that may affect borrowers’ ability to repay, estimated value of any underlying collateral, peer group data, prevailing economic conditions, and other current factors.  Large groups of smaller balance homogeneous loans, such as residential real estate, small commercial real estate, home equity and consumer loans, are evaluated in the aggregate using historical loss factors adjusted for current economic conditions and other relevant data.  Loans for which management has concerns about the borrowers’ ability to repay, are evaluated individually, and specific loss allocations are provided for these loans when necessary.

A provision for loan losses of $1.4 million was made during the three months ended March 31, 2010, compared to provision of $450,000 during the three months ended March 31, 2009.  The higher provision was primarily attributable to increases in net charge-offs, increases in our commercial loan portfolio, an increase in our overall loan portfolio and continuing declines in market conditions in the areas where we do business.

At March 31, 2010, the annualized ratio of net charge-offs to average loans increased 17 basis points to 0.67% from 0.50% at March 31, 2009.  The ratio of non-performing loans to total loans increased from 0.30% at March 31, 2009 to 0.82% at March 31, 2010.

Noninterest Income.  Noninterest income increased $550,000, or 94.0%, to $1.1 million for the three months ended March 31, 2010, from $585,000 for the three months ended March 31, 2009.  The primary reasons for this increase was an increase in mortgage servicing income due to organic growth of our servicing portfolio and the purchase of a servicing portfolio in 2009 as well as a $285,000 fair value adjustment to mortgage servicing rights.  Other significant increases in noninterest income included a $145,000 reduction in the loss on sale of assets, a $75,000 increase in gain on sale of investments and a $40,000 increase in gain on the sale of loans sold to Fannie Mae.

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Noninterest Expense.  Noninterest expense increased $579,000, or 21.6%, to $3.3 million for the three months ended March 31, 2010, compared to $2.7 million for the three months ended March 31, 2009.  The increase in the period was primarily the result of an increase in salaries and benefits of $219,000 due to staffing increases compared to the 2009 period.  Additional increases include a $169,000 increase in FDIC and OTS regulatory expenses, an $111,000 increase in occupancy expenses and a $68,000 increase in operations expense.  The increases in regulatory expenses are a result in increases in FDIC insurance charges and OTS assessments consistent in the banking industry.  The increases in salaries, operations and occupancy expenses are primarily a result of expanded operations in Tacoma and Port Angeles as well as additions to our commercial lending group.

Income Tax Expense (Benefit).  For the three months ended March 31, 2010, we incurred an income tax benefit of $7,000 on our pre-tax income as compared to an income tax expense of $7,000 for the three month period ended March 31, 2009.

Off-Balance Sheet Arrangements

In the normal course of operations, the Bank 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.

A summary of our off-balance sheet commitments to extend credit at March 31, 2010, is as follows:

Off-balance sheet loan commitments:
Commitments to make loans	$	3,517,000
Undisbursed portion of loans closed		3,071,000
Unused lines of credit		29,865,000
Irrevocable letters of credit		265,000
Total loan commitments	$	36,718,000

Liquidity

Liquidity management is both a daily and long-term function of the management of the Company and the Bank.  Excess liquidity is generally invested in short-term investments, such as overnight deposits and federal funds.  On a longer term basis, we maintain a strategy of investing in various lending products and investment securities, including mortgage-backed securities.  The Bank uses its sources of funds primarily to meet its ongoing commitments, pay maturing deposits, fund deposit withdrawals and fund loan commitments.

We maintain cash and investments that qualify as liquid assets to maintain adequate liquidity to ensure safe and sound operation and meet demands for funds (particularly withdrawals of deposits).  At March 31, 2010, the Company had $18.0 million in cash and investment securities available for sale and $2.3 million in loans held for sale which are generally available for its short-term cash needs.  We can also generate funds from borrowings, primarily FHLB.  At March 31, 2010, the Bank had the ability to borrow an additional $86.5 million in FHLB advances.

At March 31, 2010, we had $36.7 million in outstanding loan commitments, including unused lines of credit and unfunded letters of credit.  Certificates of deposit scheduled to mature in one year or less at March 31, 2010, totaled $93.5 million and have a weighted average cost of 2.3%.  It is management’s policy to maintain deposit rates that are competitive with other local financial institutions.  Based on this management strategy and our own experience, we believe that a majority of maturing

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deposits will remain with the Bank.  We do not utilize wholesale or brokered deposits to meet our funding needs.  For additional information on liquidity refer to the statement of cash flows.

Capital

The Bank is subject to minimum capital requirements imposed by the Office of Thrift Supervision (“OTS”).  Based on its capital levels at March 31, 2010, the Bank exceeded these requirements as of that date and continues to exceed them as of the date of this filing.  Consistent with our goals to operate a sound and profitable organization, our policy is for the Bank to maintain a “well-capitalized” status under the capital categories of the OTS.  Based on capital levels at March 31, 2010, the Bank was considered to be well-capitalized.  Management monitors the capital levels of the Bank to provide for current and future business opportunities and to meet regulatory guidelines for “well-capitalized” institutions.

The following table shows the capital ratios of the Bank at March 31, 2010:

	Actual					Minimum Capital Requirements					Minimum Required to Be Well-Capitalized Under Prompt Corrective  Action Provisions
	Amount		Ratio			Amount		Ratio			Amount		Ratio
	(Dollars in thousands)
Tier 1 Capital to total adjusted assets	$	25,212		7.45	%	$	13,545		4.00	%	$	16,932		5.00	%
Tier 1 Capital to risk-weighted assets	$	25,212		10.09	%	$	9,996		4.00	%	$	14,994		6.00	%
Total Capital to risk-weighted assets	$	28,344		11.34	%	$	19,991		8.00	%	$	24,989		10.00	%

____________

1.  Based on risk-weighted assets of $249,893 at March 31, 2010.

2.  Based on total adjusted assets of $338,630 at March 31, 2010.

Item 3   Quantitative and Qualitative Disclosures About Market Risk

Not required; the Company is a smaller reporting company.

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, 2010, 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, 2010, 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.

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

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to correct any deficiencies that we may discover in the future. The goal is to ensure that senior management has timely access to all material financial and non-financial information concerning the Company's business. While we believe the present design of the disclosure controls and procedures is effective to achieve this goal, future events affecting our business may cause the Company to modify its disclosure controls and procedures.

The Company does not expect that its disclosure controls and procedures will prevent all error and all fraud. A control procedure, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control procedure are met. Because of the inherent limitations in all control procedures, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any control procedure is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies and procedures may deteriorate. Because of the inherent limitations in a cost-effective control procedure, misstatements due to error or fraud may occur and not be detected.

(b) Changes in Internal Controls over Financial Reporting.

There were no changes in our internal control over financial reporting (as defined in Rule 13a - 15(f) under the Act) that occurred during the quarter ended March 31, 2010, that has materially affected, or is likely to materially affect our internal control over financial reporting.

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

(a)           Recent Sales of Unregistered Securities

Nothing to report.

(b)           Use of Proceeds

Nothing to report.

 (c)           Stock Repurchases

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On November 24, 2008, the Company announced that its Board of Directors had authorized management to repurchase up to 57,782 shares of the Company’s outstanding stock over a twelve-month period.  The repurchased shares were to be used to fund the restricted stock portion of our 2008 Equity Incentive Plan.

There were no shares repurchased under this repurchase plan during the first quarter of 2010.

Item 3    Defaults Upon Senior Securities

Nothing to report.

Item 4    Reserved

Nothing to report.

Item 5.   Other Information

Nothing to report.

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Item 6    Exhibits

Exhibit Number	Document	Reference to Prior Filing or Exhibit Number Attached Hereto
3.1	Charter for Sound Financial, Inc.	*
3.2	Bylaws of Sound Financial, Inc.	**
4	Form of Stock Certificate of Sound Financial, Inc.	**
10.1	Employment Agreement with Laura Lee Stewart	*
10.2	Executive Long Term Compensation Agreement with Laura Lee Stewart	*
10.3	Executive Long Term Compensation Agreement with Patricia Floyd	*
10.4	Sound Community Incentive Compensation Achievement Plan	*
10.5	Summary of Annual Bonus Plan	*
10.6	Summary of Quarterly Bonus Plan	*
10.7	Director Fee Arrangements for 2009	***
10.8	Sound Financial, Inc. 2008 Equity Incentive Plan	***
10.9	Form of Incentive Stock Option Agreement under the 2008 Equity Incentive Plan	+
10.10	Form of Non-Qualified Stock Option Agreement under the 2008 Equity Incentive Plan	+
10.11	Form of Restricted Stock Agreement under the 2008 Equity Incentive Plan	+
10.12	Employment Agreements with executive officers Matthew Denies, Matthew Moran, Scott Boyer and Marlene Price	++
11	Statement re computation of per share earnings	None
15	Letter re unaudited interim financial information	None
18.1	Letter re change in accounting principles	18.1
19	Reports furnished to security holders	None
22	Published report regarding matters submitted to vote of security holders	None
23	Consents	None
24	Power of Attorney	None
31.1	Rule 13a–14(a) Certification of Chief Executive Officer	31.1
31.2	Rule 13a–14(a) Certification of Chief Financial Officer	31.2
32	Section 1350 Certification	32

*	Filed as an exhibit to the Company's Form SB–2 registration statement filed on September 20, 2007 (File No.333–146196) pursuant to Section 5 of the Securities Act of 1933.
**	Filed as an exhibit to Pre-effective Amendment No. 1 to the Company's Form SB–2 registration statement filed on November 2, 2007 (File No.333–146196) pursuant to Section 5 of the Securities Act of 1933.
***	Filed as an exhibit to the Company’s Form 10-K filed on March 31, 2009.
+	Filed as an exhibit to the Company’s Form 8-K filed on January 29. 2009.
++	Filed as an exhibit to the Company’s Form 8-K filed on November 5, 2009.
+++	Filed as an exhibit to the Company’s Form 10-Q filed on May 17, 2010.

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SIGNATURES

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

		SOUND FINANICAL, INC.
May 17, 2010	By:	/s/  Laura Lee Stewart
		Laura Lee Stewart
		President and Chief Executive Officer
May 17, 2010	By:	/s/  Matthew P. Deines
		Matthew P. Deines
		Executive Vice President
		Chief Financial Officer
		Principal Financial and Accounting Officer

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Exhibit Index

18.1	Letter re change in accounting principles	18.1
31.1	Rule 13a–14(a) Certification of Chief Executive Officer	31.1
31.2	Rule 13a–14(a) Certification of Chief Financial Officer, Principal Financial and Accounting Principal	31.2
32	Section 1350 Certification	32

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