Sound Financial Bancorp (SFBC) 10-Q 2017 Q1 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

FORM 10-Q

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

For the quarterly period ended March 31, 2017

OR

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

For the transition period from to 

COMMISSION FILE NUMBER 001-35633

Sound Financial Bancorp, Inc.

(Exact Name of Registrant as Specified in its Charter)

Maryland	45-5188530
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

2400 3rd Avenue, Suite 150, Seattle, Washington	98121
(Address of principal executive offices)	(Zip Code)

Registrant’s telephone number, including area code:  (206) 448-0884

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 ☒  NO ☐

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

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

Large accelerated filer ☐	Accelerated filer ☐
Non-accelerated filer ☐	Smaller reporting company ☐
(Do not check if a smaller reporting company)
	Emerging growth company ☒

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☒

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  YES ☐  NO ☒

Indicate the number of shares outstanding of each of the registrant’s classes of common stock as of the latest practicable date.

As of May 11, 2017, there were 2,499,980 shares of the registrant’s common stock outstanding.

SOUND FINANCIAL BANCORP, 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, 2017 and December 31, 2016 (unaudited)		3
Condensed Consolidated Statements of Income for the Three Months Ended March 31, 2017 and 2016 (unaudited)		4
Condensed Consolidated Statements of Comprehensive Income for the Three Months Ended March 31, 2017 and 2016 (unaudited)		5
Condensed Consolidated Statement of Stockholders’ Equity for the Three Months Ended March 31, 2017 and 2016 (unaudited)		6
Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2017 and 2016 (unaudited)		7
Selected Notes to Condensed Consolidated Financial Statements		8
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	30
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	41
Item 4.	Controls and Procedures	41
PART II	OTHER INFORMATION
Item 1.	Legal Proceedings	42
Item 1A	Risk Factors	42
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	42
Item 3.	Defaults Upon Senior Securities	42
Item 4.	Mine Safety Disclosures	42
Item 5.	Other Information	42
Item 6.	Exhibits	42
SIGNATURES		44
EXHIBITS		45

2

SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY

Condensed Consolidated Balance Sheets (unaudited)

(In thousands, except share and per share amounts)

	March 31, 2017			December 31, 2016
ASSETS
Cash and cash equivalents	$	52,807		$	54,582
Available-for-sale securities, at fair value		6,359			6,604
Loans held for sale		1,970			871
Loans		489,290			500,001
Allowance for loan losses		(4,838	)		(4,822	)
Total loans, net		484,452			495,179
Accrued interest receivable		1,754			1,816
Bank-owned life insurance (“BOLI”), net		12,163			12,082
Other real estate owned (“OREO”) and repossessed assets, net		952			1,172
Mortgage servicing rights, at fair value		3,558			3,561
Federal Home Loan Bank (“FHLB”) stock, at cost		1,731			2,840
Premises and equipment, net		6,009			5,549
Other assets		3,621			4,127
Total assets	$	575,376		$	588,383
LIABILITIES
Deposits
Interest-bearing		409,191			403,990
Noninterest-bearing demand		71,631			63,741
Total deposits		480,822			467,731
Borrowings		25,631			54,792
Accrued interest payable		87			73
Other liabilities		6,042			4,874
Advance payments from borrowers for taxes and insurance		1,166			638
Total liabilities		513,748			528,108
COMMITMENTS AND CONTINGENCIES (NOTE 7)
STOCKHOLDERS' EQUITY
Preferred stock, $0.01 par value, 10,000,000 shares authorized, none issued or Outstanding		-			-
Common stock, $0.01 par value, 40,000,000 shares authorized, 2,499,880 and 2,498,804 shares issued and outstanding as of March 31, 2017 and December 31, 2016, respectively		25			25
Additional paid-in capital		24,134			23,979
Unearned shares - Employee Stock Ownership Plan (“ESOP”)		(683	)		(683	)
Retained earnings		38,037			36,873
Accumulated other comprehensive income, net of tax		115			81
Total stockholders’ equity		61,628			60,275
Total liabilities and stockholders’ equity	$	575,376		$	588,383

See notes to condensed consolidated financial statements

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SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY

Condensed Consolidated Statements of Income (unaudited)

(In thousands, except shares and per share amounts)

	Three Months Ended March 31,
	2017			2016
INTEREST INCOME
Loans, including fees	$	6,442		$	5,952
Interest and dividends on investments, cash and cash equivalents		150			116
Total interest income		6,592			6,068
INTEREST EXPENSE
Deposits		703			688
Borrowings		92			29
Total interest expense		795			717
Net interest income		5,797			5,351
PROVISION FOR LOAN LOSSES		-			150
Net interest income after provision for loan losses		5,797			5,201
NONINTEREST INCOME
Service charges and fee income		511			566
Earnings on cash surrender value of bank-owned life insurance		81			84
Mortgage servicing income		253			204
Fair value adjustment on mortgage servicing rights		(20	)		(114	)
Net gain on sale of loans		171			210
Total noninterest income		996			950
NONINTEREST EXPENSE
Salaries and benefits		2,691			2,563
Operations		1,021			972
Regulatory assessments		124			155
Occupancy		373			385
Data processing		407			386
Net loss on OREO and repossessed assets		3			-
Total noninterest expense		4,619			4,461
Income before provision for income taxes		2,174			1,690
Provision for income taxes		760			584
Net income	$	1,414		$	1,106
Earnings per common share:
Basic	$	0.57		$	0.45
Diluted	$	0.54		$	0.43
Weighted average number of common shares outstanding:
Basic		2,499,502			2,477,751
Diluted		2,596,519			2,571,604

See notes to condensed consolidated financial statements

4

SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY

Condensed Consolidated Statements of Comprehensive Income (unaudited)

(In thousands)

	Three Months Ended March 31,
	2017		2016
Net income	$	1,414	$	1,106
Available for sale securities:
Unrealized gains on sale of securities arising during the period, net of taxes of $17 and $4, respectively		34		6
Other comprehensive income, net of tax		34		6
Comprehensive income	$	1,448	$	1,112

See notes to condensed consolidated financial statements

5

SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY

Condensed Consolidated Statements of Stockholders’ Equity

For the Three Months Ended March 31, 2017 and 2016 (unaudited)

(In thousands, except share and per share amounts)

	Shares		Common Stock		Additional Paid-in Capital		Unearned ESOP Shares			Retained Earnings			Accumulated Other Comprehensive Income, net of tax		Total Stockholders’ Equity
Balances at December 31, 2015		2,469,206	$	25	$	23,002	$	(911	)	$	32,240		$	164	$	54,520
Net income											1,106					1,106
Other comprehensive income, net of tax														6		6
Share-based compensation						102										102
Cash dividends on common stock ($0.075 per share)											(186	)				(186	)
Restricted stock awards issued		11,606														-
Exercise of stock options		577				6										6
Balances at March 31, 2016		2,481,389	$	25	$	23,110	$	(911	)	$	33,160		$	170	$	55,554

	Shares		Common Stock		Additional Paid-in Capital		Unearned ESOP Shares			Retained Earnings			Accumulated Other Comprehensive Income, net of tax		Total Stockholders’ Equity
Balances at December 31, 2016		2,498,804	$	25	$	23,979	$	(683	)	$	36,873		$	81	$	60,275
Net income											1,414					1,414
Other comprehensive income, net of tax														34		34
Share-based compensation						144										144
Cash dividends on common stock ($0.10 per share)											(250	)				(250	)
Restricted stock awards issued		576
Exercise of stock options		500				11										11
Balances at March 31, 2017		2,499,880	$	25	$	24,134	$	(683	)	$	38,037		$	115	$	61,628

See notes to condensed consolidated financial statements

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SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY

Condensed Consolidated Statements of Cash Flows (unaudited)

(In thousands)

	Three Months Ended March 31,
	2017			2016
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	1,414		$	1,106
Adjustments to reconcile net income to net cash from operating activities:
Accretion of net premium on investments		12			10
Provision for loan losses		-			150
Depreciation and amortization		203			195
Compensation expense related to stock options and restricted stock		144			102
Fair value adjustment on mortgage servicing rights		20			114
Additions to mortgage servicing rights, net of amortization		(17	)		40
Increase in cash surrender value of BOLI		(81	)		(84	)
Net gain on sale of loans		(171	)		(210	)
Proceeds from sale of loans		14,044			13,827
Originations of loans held for sale		(14,972	)		(12,712	)
Loss on sale and write-downs of OREO and repossessed assets		(3	)		-
Change in operating assets and liabilities:
Accrued interest receivable		62			13
Other assets		489			(203	)
Accrued interest payable		14			10
Other liabilities		1,168			2,176
Net cash from operating activities		2,326			4,534
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from principal payments, maturities and sales of available for sale securities		284			409
FHLB stock redeemed		1,109			309
Net decrease (increase) in loans		10,727			(2,515	)
Proceeds from sale of OREO and other repossessed assets		223			124
Purchases of premises and equipment, net		(663	)		(824	)
Net cash from (used by) investing activities		11,680			(2,497	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase in deposits		13,091			8,097
Proceeds from borrowings		16,000			27,500
Repayment of borrowings		(45,161	)		(36,561	)
Dividends paid on common stock		(250	)		(186	)
Net change in advances from borrowers for taxes and insurance		528			522
Proceeds from stock option exercises		11			6
Net cash used by financing activities		(15,781	)		(622	)
Net (decrease) increase  in cash and cash equivalents		(1,775	)		1,415
Cash and cash equivalents, beginning of period		54,582			48,264
Cash and cash equivalents, end of period		52,807		$	49,679
SUPPLEMENTAL CASH FLOW INFORMATION:
Cash paid for income taxes	$	650		$	300
Interest paid on deposits and borrowings	$	781		$	707
Noncash net transfer from loans to OREO and repossessed assets	$	-		$	187

See notes to condensed consolidated financial statements

7

SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements (unaudited)

Note 1 – Basis of Presentation

The accompanying financial information is unaudited and has been prepared from the consolidated financial statements of Sound Financial Bancorp, Inc., and its wholly owned subsidiary, Sound Community Bank.  References in this document to Sound Financial Bancorp refer to Sound Financial Bancorp, Inc. and references to the “Bank” refer to Sound Community Bank.  References to “we,” “us,” and “our” or the “Company” refers to Sound Financial Bancorp and its wholly-owned subsidiary, Sound Community Bank, unless the context otherwise requires.

These unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X as promulgated by the Securities and Exchange Commission (“SEC”).  In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation of the financial position and results of operations for the periods presented have been included.  Certain information and disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to the rules and regulations of the SEC.  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, 2016, as filed with the SEC on March 27, 2017 (“2016 Form 10-K”).  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, 2016, included in the 2016 Form 10-K.  Certain amounts in the prior quarters’ consolidated financial statements have been reclassified to conform to the current presentation.  These classifications do not have an impact on previously reported consolidated net income, retained earnings, stockholders’ equity or earnings per share.

Note 2 – Accounting Pronouncements Recently Issued or Adopted

In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers (Topic 606), which creates Topic 606 and supersedes Topic 605, Revenue Recognition. In August 2015, FASB issued ASU No. 2015-14, Revenue from Contracts with Customers (Topic 606), which postponed the effective date of 2014-09. In March 2016, the FASB issued ASU 2016-08, Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net, which amended the principal versus agent implementation guidance set for in ASU 2014-09. Among other things, ASU 2016-08 clarifies that an entity should evaluate whether it is the principal or the agent for each specified good or service promised in a contract with a customer. In April 2016, the FASB issued ASU No. 2016-10, Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing. The ASU amends certain aspects of the guidance set forth in the FASB's new revenue standard related to identifying performance obligations and licensing implementation. The core principle of Topic 606 is that an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In general, the new ASU requires companies to use more judgment and make more estimates than under current guidance, including identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance obligation.  In May 2016, the FASB issued ASU No. 2016-12, Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients, which provides clarifying guidance in certain narrow areas and adds some practical expedients, but does not change the core revenue recognition principle in Topic 606. This ASU is effective for interim and annual periods beginning after December 15, 2017; early adoption is not permitted. For financial reporting purposes, the ASU allows for either full retrospective adoption, meaning this ASU is applied to all of the periods presented, or modified retrospective adoption, meaning the ASU  is applied only to the most current period presented in the financial statements with the cumulative effect of initially applying the ASU is recognized at the date of initial application. As a financial institution, the Company's largest component of revenue, interest income, is excluded from the scope of this ASU. Accordingly, the adoption of ASU No. 2016-12 is not expected to have a material impact on the Company’s consolidated financial statements.

8

SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements (unaudited)

In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments - Overall (Subtopic 825-10), Recognition and Measurement of Financial Assets and Financial Liabilities. The new guidance is intended to improve the recognition and measurement of financial instruments. This ASU requires equity investments (except those accounted for under the equity method of accounting, or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income. In addition, the ASU requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes and requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset (i.e., securities or loans and receivables) on the balance sheet or the accompanying notes to the financial statements. This ASU also eliminates the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet. The ASU also requires a reporting organization to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument specific credit risk (also referred to as “own credit”) when the organization has elected to measure the liability at fair value in accordance with the fair value option for financial instruments. ASU No. 2016-01 is effective for financial statements issued for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted for certain provisions. The Company is currently evaluating the impact of this ASU on the Company's consolidated financial statements.

In February 2016, FASB issued ASU No. 2016-02, Leases (Topic 842). ASU No. 2016-02 requires lessees to recognize, on the balance sheet, the assets and liabilities arising from operating leases. A lessee should recognize a liability to make lease payments and a right-of-use asset representing its right to use the underlying asset for the lease term. A lessee should include payments to be made in an optional period only if the lessee is reasonably certain to exercise an option to extend the lease or not to exercise an option to terminate the lease. For a finance lease, interest payments should be recognized separately from amortization of the right-of-use asset in the statement of comprehensive income. For operating leases, the lease cost should be allocated over the lease term on a generally straight-line basis. The amendments in ASU 2016-02 are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early application of the amendments in the ASU is permitted. Although an estimate of the impact of the new leasing standard has not yet been determined, once adopted, we expect to report higher assets and liabilities as a result of including right-of-use assets and lease liabilities related to certain banking offices and certain equipment under noncancelable operating lease agreements, however, based on current leases the adoption is not expected to have a material impact on the Company’s consolidated financial statements.

In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments- Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. This ASU replaces the existing incurred loss impairment methodology that recognizes credit losses when a probable loss has been incurred with new methodology where loss estimates are based upon lifetime expected credit losses. The amendments in this ASU require a financial asset that is measured at amortized cost to be presented at the net amount expected to be collected. The income statement would then reflect the measurement of credit losses for newly recognized financial assets as well as changes to the expected credit losses that have taken place during the reporting period. The measurement of expected credit losses will be based on historical information, current conditions, and reasonable and supportable forecasts that impact the collectability of the reported amount. Available-for-sale securities will bifurcate the fair value mark and establish an allowance for credit losses through the income statement for the credit portion of that mark. The interest portion will continue to be recognized through accumulated other comprehensive income or loss. The change in allowance recognized as a result of adoption will occur through a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the ASU is adopted. The amendments in this ASU are effective for fiscal years beginning after December 15, 2019 with early adoption permitted after December 15, 2018. The Company has begun the process to implement this new standard by working with a vendor that specializes in this area.  While the Company has not quantified the impact of this ASU, it does expect changing from the current incurred loss model to an expected loss model will result in an earlier recognition of losses. The Company also expects that once adopted the allowance for loan losses will increase, however, until its evaluation is complete the magnitude of the increase will be unknown.

9

SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements (unaudited)

In August 2016, FASB issued ASU No. 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments.  This ASU addresses the appropriate classification of eight specific cash flow issues on the cash flow statement. Debt prepayment costs should be classified as an outflow for financing activities. Settlement of zero-coupon debt instruments divides the interest portion as an outflow for operating activities and the principal portion as an outflow for financing activities. Contingent consideration payments made after a business combination should be classified as outflows for financing and operating activities. Proceeds from the settlement of bank-owned life insurance policies should be classified as inflows from investing activities. Other specific areas are identified in the ASU as to the appropriate classification of the cash inflows or outflows.  The amendments in this ASU are effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Early adoption is permitted and must be applied using a retrospective transition method to each period presented. The Company does not expect this ASU to have a material impact on the Company’s consolidated financial statements.

In March 2017, the FASB issued ASU 2017-08, Receivables-Nonrefundable Fees and Other Costs (Subtopic 310-20). ASU 2017-08 is intended to amend the amortization period for certain purchased callable debt securities held at a premium. Under ASU 2017-08, the FASB is shortening the amortization period for the premium to the earliest call date. Under current GAAP, entities generally amortize the premium as an adjustment of yield over the contractual life of the instrument. ASU 2017-08 is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2018. The Company is reviewing its securities portfolio to assess the impact the adoption of this ASU will have on the Company’s consolidated financial statements but does not expect this ASU to have a material impact.

Note 3 – Investments

The amortized cost and fair value of our available-for-sale (“AFS”) securities and the corresponding amounts of gross unrealized gains and losses at the dates indicated were as follows (in thousands):

	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Estimated Fair Value
March 31, 2017
Municipal bonds	$	3,255	$	139	$	(20	)	$	3,374
Agency mortgage-backed securities		2,612		52		(1	)		2,663
Non-agency mortgage-backed securities		338		-		(16	)		322
Total	$	6,205	$	191	$	(37	)	$	6,359
December 31, 2016
Municipal bonds	$	3,262	$	127	$	(36	)	$	3,353
Agency mortgage-backed securities		2,858		49		(3	)		2,904
Non-agency mortgage-backed securities		362		-		(15	)		347
Total	$	6,482	$	176	$	(54	)	$	6,604

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SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements (unaudited)

The amortized cost and fair value of AFS securities at March 31, 2017, by contractual maturity, are shown below (in thousands).  Expected maturities of AFS securities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.  Investments not due at a single maturity date, primarily mortgage-backed investments are shown separately.

	March 31, 2017
	Amortized Cost		Fair Value
Due in less than one year	$	-	$	-
Due in one to five years		1,344		1,323
Due after five to ten years		414		437
Due after ten years		1,497		1,614
Mortgage-backed securities		2,950		2,985
Total	$	6,205	$	6,359

There were no pledged securities at March 31, 2017 or December 31, 2016.

For the three months ended March 31, 2017 and 2016, there were no sales of AFS securities.

The following table summarizes the aggregate fair value and gross unrealized loss by length of time those investments have been in a continuous unrealized loss position at March 31, 2017 (in thousands):

	March 31, 2017
	Less Than 12 Months					12 Months or Longer					Total
	Fair Value		Unrealized Loss			Fair Value		Unrealized Loss			Fair Value		Unrealized Loss
Municipal bonds	$	1,323	$	(20	)	$	-	$	-		$	1,323	$	(20	)
Agency mortgage-backed securities		1,056		(1	)		-		-			1,056		(1	)
Non-agency mortgage-backed securities		-		-			322		(16	)		322		(16	)
Total	$	2,379	$	(21	)	$	322	$	(16	)	$	2,701	$	(37	)

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SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements (unaudited)

The following table summarizes the aggregate fair value and gross unrealized loss by length of time those investments have been in a continuous unrealized loss position at December 31, 2016 (in thousands):

	December 31, 2016
	Less Than 12 Months					12 Months or Longer					Total
	Fair Value		Unrealized Loss			Fair Value		Unrealized Loss			Fair Value		Unrealized Loss
Municipal bonds	$	1,313	$	(36	)	$	-	$	-		$	1,313	$	(36	)
Agency mortgage-backed securities		-		-			1,125		(3	)		1,125		(3	)
Non-agency mortgage-backed securities		-		-			347		(15	)		347		(15	)
Total	$	1,313	$	(36	)	$	1,472	$	(18	)	$	2,785	$	(54	)

There were no credit losses recognized in earnings during the three months ended March 31, 2017 and 2016 relating to the Company’s non- agency mortgage backed securities.

At March 31, 2017, one agency mortgage-backed security and three municipal securities were in an unrealized loss position for less than 12 months.  At December 31, 2016, three municipal securities were in a loss position for less than 12 months and one agency security was in a loss position for over 12 months.  All of the agency mortgage-backed securities in an unrealized loss position at March 31, 2017 and December 31, 2016 were issued or guaranteed by U.S. governmental agencies.  The unrealized losses were caused by changes in market interest rates or the widening of market spreads subsequent to the initial purchase of these securities, and not related to the underlying credit of the issuers or the underlying collateral.  It is expected that these securities will not be settled at a price less than the amortized cost of each investment.  Because the decline in fair value is attributable to changes in interest rates or widening market spreads and not credit quality, and because we do not intend to sell the securities in this class and it is not likely that we will be required to sell these securities before recovery of their amortized cost basis, which may include holding each security until contractual maturity, the unrealized losses on these investments are not considered an other-than-temporary impairment (“OTTI”).

As of March 31, 2017 and December 31, 2016, one non-agency mortgage-backed security was in an unrealized loss position for over 12 months.  The unrealized loss was caused by changes in interest rates causing a decline in the fair value subsequent to the purchase.  The contractual terms of this investment does not permit the issuer to settle the security at a price less than par.  Management does not intend to sell this non-agency mortgage-backed security and it is unlikely that the Company will be required to sell this security before recovery of its amortized cost basis.  Management’s impairment evaluation indicated that this security possesses qualitative and quantitative factors that do not suggest an 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.  Based upon the results of the evaluation of the quantitative and qualitative factors, the non-agency mortgage-backed security does not reflect OTTI during the three months ended March 31, 2017 or the year ended December 31, 2016.

12

SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements (unaudited)

Note 4 – Loans

The composition of the loan portfolio at the dates indicated, excluding loans held for sale, was as follows (in thousands):

	March 31, 2017			December 31, 2016
Real estate loans:
One- to four- family	$	144,948		$	152,386
Home equity		27,533			27,771
Commercial and multifamily		184,936			181,004
Construction and land		64,151			70,915
Total real estate loans		421,568			432,076
Consumer loans:
Manufactured homes		16,038			15,494
Floating homes		23,746			23,996
Other consumer		4,244			3,932
Total consumer loans		44,028			43,422
Commercial business loans		25,307			26,331
Total loans		490,903			501,829
Deferred fees		(1,613	)		(1,828	)
Total loans, gross		489,290			500,001
Allowance for loan losses		(4,838	)		(4,822	)
Total loans, net	$	484,452		$	495,179

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, 2017 (in thousands):

	One- to four- family		Home equity		Commercial and multifamily		Construction and land		Manufactured homes		Floating homes		Other consumer		Commercial business		Un- allocated		Total
Allowance for loan losses:
Individually evaluated for impairment	$	722	$	92	$	24	$	22	$	40	$	-	$	60	$	7	$	-	$	967
Collectively evaluated for impairment		813		156		1,089		391		108		137		38		147		992		3,871
Ending balance	$	1,535	$	248	$	1,113	$	413	$	148	$	137	$	98	$	154	$	992	$	4,838
Loans receivable:
Individually evaluated for impairment	$	6,408	$	1,092	$	2,112	$	81	$	272	$	-	$	62	$	396	$	-	$	10,423
Collectively evaluated for impairment		138,540		26,441		182,824		64,070		15,766		23,746		4,182		24,911		-		480,480
Ending balance	$	144,948	$	27,533	$	184,936	$	64,151	$	16,038	$	23,746	$	4,244	$	25,307	$	-	$	490,903

13

SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY

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, 2016 (in thousands):

	One-to- four family		Home equity		Commercial and multifamily		Construction and land		Manufactured homes		Floating homes		Other consumer		Commercial business		Unallocated		Total
Allowance for  loan losses:
Individually evaluated for impairment	$	536	$	121	$	24	$	35	$	59	$	-	$	65	$	23	$	-	$	863
Collectively evaluated for impairment		1,006		257		1,120		424		109		132		47		152		712		3,959
Ending balance	$	1,542	$	378	$	1,144	$	459	$	168	$	132	$	112	$	175	$	712	$	4,822
Loans  receivable:
Individually evaluated for impairment	$	4,749	$	832	$	1,582	$	83	$	312	$	-	$	62	$	616	$	-	$	8,236
Collectively evaluated for impairment		147,637		26,939		179,422		70,832		15,182		23,996		3,870		25,715		-		493,593
Ending balance	$	152,386	$	27,771	$	181,004	$	70,915	$	15,494	$	23,996	$	3,932	$	26,331	$	-	$	501,829

The following table summarizes the activity in allowance for loan losses during the three months ended March 31, 2017 (in thousands):

	Beginning Allowance		Charge-offs			Recoveries		Provision			Ending Allowance
One-to four- family	$	1,542	$	-		$	-	$	(7	)	$	1,535
Home equity		378		-			27		(157	)		248
Commercial and multifamily		1,144		(24	)		1		(8	)		1,113
Construction and land		459		-			-		(46	)		413
Manufactured homes		168		-			2		(22	)		148
Floating homes		132		-			-		5			137
Other consumer		112		(5	)		15		(24	)		98
Commercial business		175		-			-		(21	)		154
Unallocated		712		-			-		280			992
Total	$	4,822	$	(29	)	$	45	$	-		$	4,838

14

SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements (unaudited)

The following table summarizes the activity in the allowance for loan losses during the three months ended March 31, 2016 (in thousands):

	Beginning Allowance		Charge-offs			Recoveries		Provision			Ending Allowance
One-to four- family	$	1,839	$	(65	)	$	-	$	(41	)	$	1,733
Home equity		607		-			2		(12	)		597
Commercial and multifamily		921		-			-		346			1,267
Construction and land		382		-			-		81			463
Manufactured homes		301		-			2		(101	)		202
Floating homes		111		-			-		21			132
Other consumer		77		(18	)		2		40			101
Commercial business		157		-			-		7			164
Unallocated		241		-			-		(191	)		50
Total	$	4,636	$	(83	)	$	6	$	150		$	4,709

Credit Quality Indicators.  Federal regulations provide for the classification of lower quality loans as substandard, doubtful or loss.  An asset is considered substandard if it is inadequately protected by the current net worth and payment 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 loans as either substandard or doubtful, we may establish a specific allowance in an amount we deem prudent to address the risk specifically (if the loan is impaired) or we may allow the loss to be addressed in the general allowance (if the loan is not impaired).  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 loans.  When the Company classifies problem loans as a loss, we 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, doubtful or loss but possess identified weaknesses are 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 our banking regulators, which can order the establishment of additional loss allowances.  Pass rated loans are loans that are not otherwise classified or criticized.

The following table represents the internally assigned grades as of March 31, 2017 by type of loan (in thousands):

	One- to four- family		Home equity		Commercial and multifamily		Construction and land		Manufactured homes		Floating homes		Other consumer		Commercial business		Total
Grade:
Pass	$	139,558	$	26,320	$	172,440	$	57,868	$	15,828	$	23,746	$	4,135	$	24,689	$	464,584
Watch		950		363		10,743		6,283		102		-		47		315		18,803
Special Mention		139		-		364		-		29		-		2		158		692
Substandard		4,301		850		1,389		-		79		-		60		145		6,824
Doubtful		-		-		-		-		-		-		-		-		-
Loss		-		-		-		-		-		-		-		-		-
Total	$	144,948	$	27,533	$	184,936	$	64,151	$	16,038	$	23,746	$	4,244	$	25,307	$	490,903

15

SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements (unaudited)

The following table represents the internally assigned grades as of December 31, 2016 by type of loan (in thousands):

	One- to four- family		Home equity		Commercial and multifamily		Construction and land		Manufactured homes		Floating homes		Other consumer		Commercial business		Total
Grade:
Pass	$	148,617	$	26,547	$	171,678	$	67,539	$	15,288	$	23,996	$	3,821	$	25,625	$	483,111
Watch		998		536		8,105		3,376		78		-		49		326		13,468
Special Mention		139		-		-		-		30		-		-		-		169
Substandard		2,632		688		1,221		-		98		-		62		380		5,081
Doubtful		-		-		-		-		-		-		-		-		-
Loss		-		-		-		-		-		-		-		-		-
Total	$	152,386	$	27,771	$	181,004	$	70,915	$	15,494	$	23,996	$	3,932	$	26,331	$	501,829

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 sooner 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, 2017 and December 31, 2016, by type of loan (in thousands):

	March 31, 2017		December 31, 2016
One- to four- family	$	733	$	2,169
Home equity		782		536
Commercial and multifamily		215		218
Manufactured homes		47		72
Commercial business		145		149
Total	$	1,922	$	3,144

16

SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY

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, 2017 by type of loan (in thousands):

	30-59 Days Past Due		60-89 Days Past Due		90 Days and Greater Past Due		90 Days and Greater Past Due and Still Accruing		Total Past Due		Current		Total Loans
One-to four- family	$	1,079	$	63	$	530	$	-	$	1,672	$	143,276	$	144,948
Home equity		307		90		594		-		991		26,542		27,533
Commercial and multifamily		-		-		-		-		-		184,936		184,936
Construction and land		27		-		-		-		27		64,124		64,151
Manufactured homes		407		37		46		-		490		15,548		16,038
Floating homes		-		-		-		-		-		23,746		23,746
Other consumer		7		1		-		-		8		4,236		4,244
Commercial business		145		-		-		-		145		25,162		25,307
Total	$	1,972	$	191	$	1,170	$	-	$	3,333	$	487,570	$	490,903

The following table represents the aging of the recorded investment in past due loans as of December 31, 2016 by type of loan (in thousands):

	30-59 Days Past Due		60-89 Days Past Due		90 Days and Greater Past Due		90 Days and Greater Past Due and Still Accruing		Total Past Due		Current		Total Loans
One-to four- family	$	2,476	$	161	$	1,787	$	-	$	4,424	$	147,962	$	152,386
Home equity		460		-		494		-		954		26,817		27,771
Commercial and multifamily		-		-		-		-		-		181,004		181,004
Construction and land		440		-		-		-		440		70,475		70,915
Manufactured homes		321		28		62		-		411		15,083		15,494
Floating homes		-		-		-		-		-		23,996		23,996
Other consumer		26		1		-		-		27		3,905		3,932
Commercial business		149		-		-		-		149		26,182		26,331
Total	$	3,872	$	190	$	2,343	$	-	$	6,405	$	495,424	$	501,829

17

SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements (unaudited)

Nonperforming Loans.  Loans are considered nonperforming when they are placed on nonaccrual and/or when they are considered to be nonperforming troubled debt restructurings (“TDRs”) and/or when they are 90 days or greater past due and still accruing interest.  A TDR is a loan to a borrower who 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.  Once a TDR has performed according to its modified terms for six months and the collection of principal and interest under the revised terms is deemed probable, we remove the TDR from nonperforming status. Nonperforming TDRs include TDRs that do not have sufficient payment history (typically greater than six months) to be considered performing or TDRs that have become 31 or more days past due.

The following table represents the credit risk profile of our loan portfolio based on payment activity as of March 31, 2017 by type of loan (in thousands):

	One- to four- family		Home equity		Commercial and multifamily		Construction and land		Manufactured homes		Floating Homes		Other consumer		Commercial business		Total
Performing	$	142,892	$	26,734	$	184,721	$	64,151	$	15,968	$	23,746	$	4,244	$	25,069	$	487,525
Nonperforming		2,056		799		215		-		70		-		-		238		3,378
Total	$	144,948	$	27,533	$	184,936	$	64,151	$	16,038	$	23,746	$	4,244	$	25,307	$	490,903

The following table represents the credit risk profile of our loan portfolio based on payment activity as of December 31, 2016 by type of loan (in thousands):

	One- to four- family		Home equity		Commercial and multifamily		Construction and land		Manufactured homes		Floating Homes		Other consumer		Commercial business		Total
Performing	$	150,170	$	27,218	$	180,786	$	70,915	$	15,374	$	23,996	$	3,932	$	26,089	$	498,480
Nonperforming		2,216		553		218		-		120		-		-		242		3,349
Total	$	152,386	$	27,771	$	181,004	$	70,915	$	15,494	$	23,996	$	3,932	$	26,331	$	501,829

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 loan and the borrower(s), including payment history, the amount 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.  All TDRs 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.

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SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements (unaudited)

The following table presents loans individually evaluated for impairment at March 31, 2017 by type of loan (in thousands):

	March 31, 2017
			Recorded Investment
	Unpaid Principal Balance		Without Allowance		With Allowance		Related Allowance
One- to four- family	$	6,512	$	2,801	$	3,607	$	722
Home equity		1,092		659		433		92
Commercial and multifamily		2,117		1,753		359		24
Construction and land		81		-		81		22
Manufactured homes		273		71		201		40
Floating homes		-		-		-		-
Other consumer		62		2		60		60
Commercial business		396		303		93		7
Total	$	10,533	$	5,589	$	4,834	$	967

The following table presents loans individually evaluated for impairment at December 31, 2016 by type of loan (in thousands):

	December 31, 2016
			Recorded Investment
	Unpaid Principal Balance		Without Allowance		With Allowance		Related Allowance
One- to four- family	$	5,010	$	2,454	$	2,295	$	536
Home equity		913		446		386		121
Commercial and multifamily		1,582		1,221		361		24
Construction and land		83		-		83		35
Manufactured homes		326		91		221		59
Floating homes		-		-		-		-
Other consumer		62		-		62		65
Commercial business		616		143		473		23
Total	$	8,592	$	4,355	$	3,881	$	863

19

SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements (unaudited)

The following table presents loans individually evaluated for impairment as of March 31, 2017 and 2016 by type of loan (in thousands):

	March 31, 2017				March 31, 2016
	Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
One- to four- family	$	4,959	$	84	$	5,623	$	68
Home equity		965		10		921		12
Commercial and multifamily		1,852		27		3,439		67
Construction and land		82		1		90		1
Manufactured homes		302		5		371		7
Floating homes		-		-		-		-
Other consumer		63		1		16		1
Commercial business		505		5		307		7
Total	$	8,728	$	133	$	10,767	$	163

Forgone interest on nonaccrual loans was $4,000 and $22,000 for the three months ended March 31, 2017 and 2016, respectively.  There were no commitments to lend additional funds to borrowers whose loans were classified as nonaccrual, TDR or impaired at March 31, 2017 or December 31, 2016.

Troubled debt restructurings.  Loans classified as TDRs totaled $4.7 million and $3.4 million at March 31, 2017 and December 31, 2016, respectively, and are included in impaired loans.  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 is 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.

There was one $1.3 million one- to four- family residential TDR loan identified during the quarter ended March 31, 2017 and one $14,000 manufactured house TDR loan that paid off during the period.  At March 31, 2017, there were no commitments to extend additional credit to borrowers whose loan terms have been modified in TDRs. There were no loans modified as TDRs within the previous 12 months for which there was a payment default during the three months ended March 31, 2017 and 2016.

20

SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements (unaudited)

Note 5 – Fair Value Measurements

The following tables present information about the level in the fair value hierarchy for the Company’s financial assets and liabilities, whether or not recognized or recorded at fair value as of March 31, 2017 and December 31, 2016 (in thousands):

	March 31, 2017				Fair Value Measurements Using:
	Carrying Value		Estimated Fair Value		Level 1		Level 2		Level 3
FINANCIAL ASSETS:
Cash and cash equivalents	$	52,807	$	52,807	$	52,807	$	-	$	-
Available-for-sale  securities		6,359		6,359		-		6,037		322
Loans held for sale		1,970		1,970		-		1,970		-
Loans receivable, net		484,452		483,245		-		-		483,245
Accrued interest receivable		1,754		1,754		1,754		-
Mortgage servicing rights		3,558		3,558		-		-		3,558
FHLB stock		1,731		1,731		-		-		1,731
FINANCIAL LIABILITIES:
Non-maturity deposits		328,115		328,115		-		328,115		-
Time deposits		152,707		150,573		-		150,573		-
Borrowings		25,631		25,635		-		25,635		-
Accrued interest payable		87		87		-		87		-

	December 31, 2016				Fair Value Measurements Using:
	Carrying Value		Estimated Fair Value		Level 1		Level 2		Level 3
FINANCIAL ASSETS:
Cash and cash equivalents	$	54,582	$	54,582	$	54,582	$	-	$	-
Available-for-sale securities		6,604		6,604		-		6,257		347
Loans held for sale		871		871		-		871		-
Loans receivable, net		495,179		494,289		-		-		494,289
Accrued interest receivable		1,816		1,816		1,816		-		-
Mortgage servicing rights		3,561		3,561		-		-		3,561
FHLB Stock		2,840		2,840		-		-		2,840
FINANCIAL LIABILITIES:
Non-maturity deposits		307,989		307,989		-		307,989		-
Time deposits		159,742		159,333		-		159,333		-
Borrowings		54,792		54,805		-		54,805		-
Accrued interest payable		73		73		-		73		-

21

SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements (unaudited)

The following tables present the balance of assets measured at fair value on a recurring basis as of March 31, 2017 and December 31, 2016 (in thousands):

	Fair Value at March 31, 2017
Description	Total		Level 1		Level 2		Level 3
Municipal bonds	$	3,374	$	-	$	3,374	$	-
Agency mortgage-backed securities		2,663		-		2,663		-
Non-agency mortgage-backed securities		322		-		-		322
Mortgage servicing rights		3,558		-		-		3,558

	Fair Value at December 31, 2016
Description	Total		Level 1		Level 2		Level 3
Municipal bonds	$	3,353	$	-	$	3,353	$	-
Agency mortgage-backed securities		2,904		-		2,904		-
Non-agency mortgage-backed securities		347		-		-		347
Mortgage servicing rights		3,561		-		-		3,561

For the three months ended March 31, 2017 and 2016 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, 2017 and December 31, 2016:

March 31, 2017
Financial Instrument	Valuation Technique	Unobservable Input(s)	Range (Weighted Average)
Mortgage Servicing Rights	Discounted cash flow	Prepayment speed assumption	104-381% (149%)
		Discount rate	13-15% (13%)
Non-agency mortgage-backed securities	Discounted cash flow	Discount rate	7-9% (8%)

December 31, 2016
Financial Instrument	Valuation Technique	Unobservable Input(s)	Range (Weighted Average)
Mortgage Servicing Rights	Discounted cash flow	Prepayment speed assumption	104-396% (152%)
		Discount rate	13%-15% (13%)
Non-agency mortgage-backed securities	Discounted cash flow	Discount rate	7%-9% (8%)

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.

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SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements (unaudited)

The following table provides a reconciliation of assets and liabilities (excluding mortgage servicing rights) measured at fair value using significant unobservable inputs (Level 3) on a recurring basis during the three months ended March 31, 2017 and 2016 (in thousands):

	Three Months Ended March 31,
	2017			2016
Beginning balance, at fair value	$	347		$	428
OTTI impairment losses		-			-
Sales and principal payments		(24	)		(15	)
Change in unrealized loss		(1	)		2
Ending balance, at fair value	$	322		$	415

Mortgage servicing rights are measured at fair value using significant unobservable input (Level 3) on a recurring basis and a reconciliation of this asset can be found in Note 6 – Mortgage Servicing Rights.

The following tables present the balance of assets measured at fair value on a nonrecurring basis at the dates indicated (in thousands):

	Fair Value at March 31, 2017
	Total		Level 1		Level 2		Level 3
OREO and repossessed assets	$	952	$	-	$	-	$	952
Impaired loans		10,423		-		-		10,423

	Fair Value at December 31, 2016
	Total		Level 1		Level 2		Level 3
OREO and repossessed assets	$	1,172	$	-	$	-	$	1,172
Impaired loans		8,236		-		-		8,236

There were no liabilities carried at fair value, measured on a recurring or nonrecurring basis, at March 31, 2017 or December 31, 2016.

The following table provides a description of the valuation technique, observable 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 nonrecurring basis at March 31, 2017 and December 31, 2016:

March 31, 2017
Financial Instrument	Valuation Technique(s)	Unobservable Input(s)	Range (Weighted Average)
OREO	Market approach	Adjustment for differences between comparable sales	0-0% (0%)
Impaired loans	Market approach	Adjustment for differences between comparable sales	0-100% (7%)

December 31, 2016
Financial Instrument	Valuation Technique(s)	Unobservable Input(s)	Range (Weighted Average)
OREO	Market approach	Adjusted for difference between comparable sales	0-0% (0%)
Impaired loans	Market approach	Adjusted for difference between comparable sales	0-100% (10.5%)

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SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements (unaudited)

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.

OREO and Repossessed Assets – The fair value of OREO and repossessed assets is based on the current appraised value of the collateralor internally developed models utilizing a calculation of expected discounted cash flows which contain management’s assumptions.

The following methods and assumptions were used to estimate the fair value of other financial instruments:

Cash and Cash Equivalents, Accrued Interest Receivable and Payable - 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 2 securities include those traded on an active exchange, as well as U.S. government and its agencies securities.  Level 3 securities include private label mortgage-backed securities.

Loans Held for Sale - The fair value of fixed-rate residential loans is based on whole loan forward prices obtained from government sponsored enterprises. At March 31, 2017 and December 31, 2016, loans held for sale were carried at cost as no impairment was required.

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.

Mortgage Servicing Rights –The fair value of mortgage servicing rights is determined though a discounted cash flow analysis, which uses interest rates, prepayment speeds, discount rates, and delinquency rate assumptions as inputs.

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

Deposits - The estimated fair value of deposit accounts (savings, demand deposit, and money market accounts) is the carrying amount. The fair values 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.

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SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements (unaudited)

Note 6 – Mortgage Servicing Rights

The unpaid principal balances of loans serviced for the Federal National Mortgage Association at March 31, 2017 and December 31, 2016, totaled approximately $402.6 million and $410.1 million, respectively, and are not included in the Company’s financial statements.  We also service loans for other financial institutions for which a servicing fee is received.  The unpaid principal balances of loans serviced for other financial institutions at March 31, 2017 and December 31, 2016, totaled approximately $16.1 million and $13.8 million, respectively, and are not included in the Company’s financial statements.

A summary of the change in the balance of mortgage servicing rights during the three months ended March 31, 2017 and 2016 were as follows (in thousands):

	Three Months Ended March 31,
	2017			2016
Beginning balance, at fair value	$	3,561		$	3,249
Servicing rights that result from transfers and purchases of financial assets		17			108
Changes in fair value:
Due to changes in model inputs or assumptions(1)		(20	)		(114	)
Other(2)		-			(148	)
Ending balance, at fair value	$	3,558		$	3,095

⁽¹⁾ Represents changes in discount rates and prepayment speed assumptions, which are primarily affected by changes in interest rates.

⁽²⁾ Represents changes due to collection or realization of expected cash flows over time.

The key economic assumptions used in determining the fair value of mortgage servicing rights at the dates indicated are as follows:

	March 31, 2017			December 31, 2016
Prepayment speed (Public Securities Association “PSA” model)		149	%		152	%
Weighted-average life (years)		7.2			7.2
Yield to maturity discount rate		13	%		13	%

The amount of contractually specified servicing, late and ancillary fees earned and recorded in mortgage servicing income on the Condensed Consolidated Statements of Income was $253,000 and $204,000 for the three months ended March 31, 2017 and 2016, respectively.

Note 7 – 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.

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SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements (unaudited)

At various times, the Company may be the defendant in various legal proceedings arising in connection with its business. It is the opinion of management that the financial position and the results of operations of the Company will not be materially adversely affected by the outcome of these legal proceedings and that adequate provision has been made in the accompanying consolidated financial statements.

Note 8 – Borrowings and FHLB Stock

The Company utilizes a loan agreement with the FHLB of Des Moines. The terms of the agreement call for a blanket pledge of a portion of the Company’s mortgage, commercial and multifamily portfolio based on the outstanding balance.  At March 31, 2017 and December 31, 2016, the amount available to borrow under this credit facility was $205.7 million and $197.9 million, respectively.  At March 31, 2017, the credit facility was collateralized as follows: one- to four- family mortgage loans with an advance equivalent of $107.0 million, commercial and multifamily mortgage loans with an advance equivalent of $100.5 million and home equity loans with an advance equivalent of $15.3 million.  At December 31, 2016, the credit facility was collateralized as follows: one- to four- family mortgage loans with an advance equivalent of $107.2 million, commercial and multifamily mortgage loans with an advance equivalent of $94.4 million and home equity loans with an advance equivalent of $15.9 million.  The Company had outstanding borrowings under this arrangement of $25.6 million and $54.8 million at March 31, 2017 and December 31, 2016, respectively.  Additionally, the Company had outstanding letters of credit from the FHLB of Des Moines with a notional amount of $16.0 million at March 31, 2017 and $21.0 million at December 31, 2016 to secure public deposits. The net remaining amount available as of March 31, 2017 and December 31, 2016, was $164.1 million and $122.2 million, respectively.

As a member of the FHLB system, the Company is required to maintain a minimum level of investment in FHLB stock based on specific percentages of its outstanding mortgages, total assets, or FHLB advances.  At March 31, 2017 and December 31, 2016, the Company’s minimum required investment in FHLB stock was $1.7 million and $2.8 million, respectively.

The Company participates in the Federal Reserve Bank 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 $41.8 million and $42.0 million and no outstanding borrowings under this program at March 31, 2017 and December 31, 2016, respectively.

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, 2017 and is renewable annually.  As of March 31, 2017, the amount available under this line of credit was $2.0 million.  There was no balance on this line of credit as of March 31, 2017 and December 31, 2016, respectively.

The Company has access to a Fed Funds line of credit from Zions Bank under a Fed Funds Sweep and Line Agreement established September 26, 2013.  The agreement allows access to a Fed Funds line of up to $9.0 million and requires the Company to maintain cash balances with Zions Bank of $250,000.  The agreement has no maturity date.  There was no balance on this line of credit as of March 31, 2017 and December 31, 2016, respectively.

The Company has access to an unsecured line of credit from The Independent Bank (TIB). As of March 31, 2017, the amount available under this line of credit was $10.0 million. There was no balance on this line of credit as of March 31, 2017 and December 31, 2016, respectively.

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SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements (unaudited)

Note 9 – Earnings Per Common Share

Basic earnings per common share is computed by dividing net income (which has been adjusted for distributed and undistributed earnings to participating securities) by the weighted-average number of common shares outstanding for the period, reduced for average unallocated ESOP shares and average unvested restricted stock awards. Unvested share-based awards that contain non-forfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of earnings per share pursuant to the two-class method described in ASC 260-10-45-60B.  Diluted earnings per common share reflects the potential dilution that could occur if securities or other contracts to issue common stock (such as stock awards and options) were exercised or converted to common stock, or resulted in the issuance of common stock that then shared in the Company’s earnings. Diluted earnings per common share is computed by dividing net income by the weighted-average number of common shares outstanding for the period increased for the dilutive effect of unexercised stock options and unvested restricted stock awards. The dilutive effect of the unexercised stock options and unvested restricted stock awards is calculated under the treasury stock method utilizing the average market value of the Company’s stock for the period.

Earnings per share are summarized for the periods presented in the following table (in thousands, except per share data):

	Three Months Ended March 31,
	2017		2016
Net income	$	1,414	$	1,106
Weighted average number of shares outstanding, basic		2,500		2,478
Effect of potentially dilutive common shares(1)		98		94
Weighted average number of shares outstanding, diluted		2,597		2,572
Earnings per share, basic	$	0.57	$	0.45
Earnings per share, diluted	$	0.54	$	0.43

⁽¹⁾ Represents the effect of the assumed exercise of stock options and vesting of non-participating restricted shares, based on the treasury stock method.

There were no shares considered anti-dilutive for the three months ended March 31, 2017 or 2016.

Note 10 – Stock-based Compensation

Stock Options and Restricted Stock

The Company currently has two existing Equity Incentive Plans, a 2008 Equity Inventive Plan (the”2008 Plan”) and a 2013 Equity Incentive Plan (the “2013 Plan”, and together with the 2008 Plan (the “Plans”)), both of which were approved by shareholders.  The Plans permit the grant of restricted stock, restricted stock units, stock options, and stock appreciation rights.  Under the 2008 Plan, 126,287 shares of common stock were approved for awards for stock options and stock appreciation rights and 50,514 shares of common stock were approved for awards for restricted stock and restricted stock units.  Under the 2013 Plan, 141,750 shares of common stock were approved for awards for stock options and stock appreciation rights and 56,700 shares of common stock were approved for awards for restricted stock and restricted stock units.

As of March 31, 2017, on an adjusted basis, awards for stock options totaling 265,801 shares and awards for restricted stock totaling 107,213 shares of Company common stock have been granted, net of any forfeitures, to participants in the Plans.  During the three months ended March 31, 2017 and 2016, share-based compensation expense totaled $144,000 and $102,000, respectively.

Stock Option Awards

The stock option awards granted to date under the 2008 Plan vest in 20 percent annual increments commencing one year from the grant date in accordance with the requirements of the 2008 Plan.  The stock option awards granted to date under the 2013 Plan vest in equal annual installments of either two or four years.  All of the options granted under the Plans are exercisable for a period of 10 years from the date of grant, subject to vesting.

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SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements (unaudited)

The following is a summary of the Company’s stock option award activity during the three months ended March 31, 2017:

	Shares			Weighted- Average Exercise Price		Weighted- Average Remaining Contractual Term In Years		Aggregate Intrinsic Value
Outstanding at the beginning of the year		170,057		$	15.41		6.44	$	2,141,018
Granted		32,010			28.34
Exercised		(500	)		22.31
Forfeited		(600	)		28.34
Expired		-			-
Outstanding at March 31, 2017		200,967			17.42		6.77	$	2,877,847
Exercisable		133,407			15.58		6.10	$	2,155,857
Expected to vest, assuming a 0% forfeiture rate over the vesting term		67,560			21.05		8.07	$	722,296

As of March 31, 2017, there was $459,000 of total unrecognized compensation cost related to non-vested stock options granted under the Plans.  The cost is expected to be recognized over the remaining weighted-average vesting period of 2.05 years.

The fair value of each option grant is estimated as of the grant date using the Black-Scholes option-pricing model.  The fair value of options granted for the three months ended March 31, 2017 was determined using the following weighted-average assumptions as of the grant date.

Annual dividend yield		1.28	%
Expected volatility		22.99	%
Risk-free interest rate		2.20	%
Expected term	6.50 years
Weighted-average grant date fair value per option granted	$	6.62

The fair value of options granted for the three months ended March 31, 2016 was determined using the following weighted-average assumptions as of the grant date.

Annual dividend yield		1.03	%
Expected volatility		25.48	%
Risk-free interest rate		1.64	%
Expected term	6.92 years
Weighted-average grant date fair value per option granted	$	5.78

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. The restricted stock awards granted to date under the 2008 Plan provide for vesting in 20% annual increments commencing one year from the grant date.  The restricted stock awards granted to date under the 2013 Plan provide for immediate vesting of 33.33% of a recipient’s award with the balance of an individual’s award under the 2013 Plan vesting in two equal annual installments commencing one year from the grant date.

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SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements (unaudited)

The following is a summary of the Company’s non-vested restricted stock awards during the three months ended March 31, 2017:

Non-vested Shares	Shares			Weighted-Average Grant-Date Fair Value Per Share
Non-vested at January 1, 2017		26,138		$	18.08
Granted		576		$	28.34
Vested		(14,950	)	$	18.93
Forfeited		-			-
Expired		-			-
Non-vested at March 31, 2017		11,764		$	19.05
Expected to vest assuming a 0% forfeiture rate over the vesting term		11,764		$	19.05

As of March 31, 2017, there was $253,000 of unrecognized compensation cost related to non-vested restricted stock granted under the Plans.  The cost is expected to be recognized over the weighted-average vesting period of 1.03 years.  The total fair value of shares vested for the three months ended March 31, 2017 and 2016 was $283,000 and $345,000, respectively.

Employee Stock Ownership Plan

In January 2008, the ESOP borrowed $1.2 million from the Company to purchase common stock of the Company.  In August 2012, in conjunction with the Company’s conversion to a full stock company from the mutual holding company structure, the ESOP borrowed an additional $1.1 million from the Company to purchase common stock of the Company.  Both loans are being repaid principally by the Bank through contributions to the ESOP over a period of ten years.  The interest rate on the loans is fixed at 4.00% and 2.25%, per annum, respectively.  As of March 31, 2017, the remaining balances of the ESOP loans were $136,000 and $590,000, respectively.

Neither the loan balances nor the related interest expense are reflected on the condensed consolidated financial statements.

At March 31, 2017, the ESOP was committed to release 21,443 shares of the Company’s common stock to participants and held 66,800 unallocated shares remaining to be released in future years.  The fair value of the 183,469restricted shares held by the ESOP trust was $5.8 million at March 31, 2017.  ESOP compensation expense included in salaries and benefits was $168,000 and $136,000 for the three months ended March 31, 2017 and 2016, respectively.

Note 11 – Subsequent Event

On April 25, 2017, the Company declared a quarterly cash dividend of $0.10 per common share, payable on May 26, 2017 to shareholders of record at the close of business May 12, 2017.

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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

Special Note Regarding Forward-Looking Statements

Certain matters discussed in this Form 10-Q constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements relate to our financial condition, results of operations, plans, objectives, future performance or business. Forward-looking statements are not statements of historical fact, are based on certain assumptions and are generally identified by use of the words “believes,” “expects,” “anticipates,” “estimates,” “forecasts,” “intends,” “plans,” “targets,” “potentially,” “probably,” “projects,” “outlook” or similar expressions or future or conditional verbs such as “may,” “will,” “should,” “would” and “could.” Forward-looking statements include statements with respect to our beliefs, plans, objectives, goals, expectations, assumptions and statements about, among other things, expectations of the business environment in which we operate, projections of future performance or financial items, perceived opportunities in the market, potential future credit experience, and statements regarding our mission and vision. These forward-looking statements are based upon current management expectations and may, therefore, involve risks and uncertainties. Our actual results, performance, or achievements may differ materially from those suggested, expressed, or implied by forward-looking statements as a result of a wide variety or range of factors including, but not limited to:

· 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, including the pending University Place, Washington branch acquisition;

· legislative or regulatory changes such as the Dodd-Frank Wall Street Reform and Consumer Protection Act and its implementing regulations that adversely affect our business, as well as changes in regulatory policies and principles, or  the interpretation of regulatory capital or other rules including changes related to Basel III;

· monetary and fiscal policies of the Board of Governors of the Federal Reserve System (“Federal Reserve”) and the U.S. Government and other governmental initiatives affecting the financial services industry;

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· results of examinations of Sound Financial Bancorp 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;

· 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;

· our ability to keep pace with technological changes, including our ability to identify and address cyber-security risks such as data security breaches, “denial of service” attacks, “hacking” and identity theft;

· 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 U.S. Securities and Exchange Commission (the “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.

31

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.

General

Sound Financial Bancorp, a Maryland corporation, is a bank holding company for its wholly owned subsidiary, Sound Community Bank.  Substantially all of Sound Financial Bancorp's business is conducted through Sound Community Bank, a Washington state-chartered commercial bank.  As a Washington commercial bank, the Bank's regulators are the Washington State Department of Financial Institutions ("WDFI") and the Federal Deposit Insurance Corporation (“FDIC”).  The Federal Reserve is the primary federal regulator for Sound Financial Bancorp.

Sound Community Bank’s deposits are insured up to applicable limits by the FDIC.  At March 31, 2017, Sound Financial Bancorp had total consolidated assets of $575.4 million, net loans of $484.5 million, deposits of $480.8 million and stockholders’ equity of $61.6 million.  The shares of Sound Financial Bancorp are traded on The NASDAQ Capital Market under the symbol “SFBC.”  Our executive offices are located at 2400 3^rd Avenue, Suite 150, Seattle, Washington, 98121.

Our principal business consists of attracting retail and commercial 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 real estate, construction and land, consumer and commercial business loans.  Our commercial business loans include unsecured lines of credit and secured term loans and lines of credit secured by inventory, equipment and accounts receivable.  We also offer a variety of secured and unsecured consumer loan products, including manufactured home loans, floating home loans, automobile loans, boat loans and recreational vehicle loans.  As part of our business, we focus on residential mortgage loan originations, the majority of which we sell to the Federal National Mortgage Association and a portion of which we retain for our loan portfolio consistent with our asset/liability objectives.  We sell loans which conform to the underwriting standards of Fannie Mae (“conforming”) with servicing retained to maintain the direct customer relationship and to generate noninterest income.  Residential loans which do not conform to the underwriting standards of Fannie Mae (“non-conforming”), are either held in our loan portfolio or sold with servicing released.  We originate and retain a significant amount of commercial real estate loans, including those secured by owner-occupied and nonowner-occupied commercial real estate, multifamily property, mobile home parks and construction and land development loans.

Critical Accounting Policies

Certain of our accounting policies are important to an understanding of our financial condition, since they require management to make difficult, complex or subjective judgments, which may relate to matters that are inherently uncertain.  Estimates associated with these policies are susceptible to material changes as a result of changes in facts and circumstances.  Facts and circumstances that could affect these judgments include, but are not limited to, changes in interest rates, changes in the performance of the economy and changes in the financial condition of borrowers.  Management believes that its critical accounting policies include determining the allowance for loan losses, accounting for other-than-temporary impairment of securities, and accounting for mortgage servicing rights, accounting for other real estate owned, and accounting for deferred income taxes.  Our methodologies for analyzing the allowance for loan losses, other-than-temporary impairment of securities, mortgage servicing rights, other real estate owned and deferred income tax asset accounts are described in our 2016 Form 10-K.  There have been no significant changes in the Company’s application of accounting policies since December 31, 2016.

32

Comparison of Financial Condition at March 31, 2017 and December 31, 2016

General.   Total assets decreased $13.0 million, or 2.2%, to $575.4 million at March 31, 2017 from $588.4 million at December 31, 2016.  This decrease was primarily the result of a $10.7 million, or 2.2%, decrease in the net loan portfolio, a $1.8 million, or 3.3%, decrease in cash and cash equivalents and a $1.1 million, or 39.0%, decrease in FHLB stock, partially offset by a $1.1 million, or 126.2%, increase in loans held-for-sale.  Excess liquidity from a $13.1 million, or 2.8%, increase in deposits combined with the decline in the net loan portfolio was primarily used to pay down borrowings by $29.2 million.

Cash and Securities.  Cash, cash equivalents and our available-for-sale securities in the aggregate decreased by $2.0 million, or 3.3%, to $59.2 million at March 31, 2017 from $61.2 million at December 31, 2016.  Cash and cash equivalents decreased by $1.8 million, or 3.3%, to $52.8 million at March 31, 2017.  Available-for-sale securities, which consist primarily of agency mortgage-backed securities, decreased by $245,000, or 3.7%, from $6.6 million at December 31, 2016 to $6.4 million at March 31, 2017 as a result of principal repayments and prepayments.  There were no sales of securities during the three months ended March 31, 2017 and 2016.  For further analysis on our investment securities, see Note 3 – Investments in the Notes to Consolidated Financial Statements under Item 1 of this report.

Loans.  Our gross loan portfolio, excluding loans held for sale, decreased $10.7 million, or 2.1%, to $489.3 million at March 31, 2017 from $500.0 million at December 31, 2016.

Loans held for saleincreased$1.1 million, or 126.2%, to $2.0 million at March 31, 2017 from $871,000 at December 31, 2016.  The increase in loans held for sale was a result of the timing of loan sales.

The following table reflects the changes in the types of loans in our gross loan portfolio at March 31, 2017, as compared to December 31, 2016 (dollars in thousands):

	March 31, 2017			December 31, 2016			Amount Change			Percent Change
One-to-four-family	$	144,948		$	152,386		$	(7,438	)		(4.9	)%
Home equity		27,533			27,771			(238	)		(0.9	)
Commercial and multifamily		184,936			181,004			3,932			2.2
Construction and land		64,151			70,915			(6,764	)		(9.5	)
Manufactured homes		16,038			15,494			544			3.5
Floating homes		23,746			23,996			(250	)		(1.0	)
Other consumer		4,244			3,932			312			7.9
Commercial business		25,307			26,331			(1,024	)		(3.9	)
Deferred loan fees		(1,613	)		(1,828	)		215			(11.7	)
Total loans, gross	$	489,290		$	500,001		$	(10,711	)		(2.1	)

The decreases in our gross loan portfolio were primarily a result of loan pay downs and pay-offs exceeding loan production.  We have experienced a decline in the number of purchase and refinancing transactions during the first quarter, in addition, the inventory of houses for sale has been very low in the Puget Sound area, resulting in a decline in our residential loan portfolio since December 31, 2016.  Residential loan closings for the first quarter of 2017 declined 46.9% to $20.3 million compared to $38.2 million during the fourth quarter of 2016.  We experienced a decline in every loan category at March 31, 2017 compared to December 31, 2016, except commercial and multifamily, manufactured housing and other consumer loans. At March 31, 2017, commercial and multifamily real estate loans accounted for 37.7% of the portfolio and one- to four- family residential loans accounted for 29.5% of the portfolio and consumer loans, consisting of home equity, manufactured and floating homes, and other consumer loans accounted for 14.6% of the portfolio.  Construction and land loans accounted for 13.1% of the portfolio and commercial and industrial loans accounted for the remaining 5.2% of the portfolio at March 31, 2017.

Mortgage Servicing Rights.  At both March 31, 2017 and December 31, 2016, we had $3.6 million in mortgage servicing rights recorded at fair value.  We record mortgage servicing rights on loans sold to Fannie Mae and other financial institutions with servicing retained and upon acquisition of a servicing portfolio.  We stratify our capitalized mortgage servicing rights based on the type, term and interest rates of the underlying loans.  Mortgage servicing rights are carried at fair value.  If the fair value of our mortgage servicing rights fluctuates significantly, our financial results could be materially impacted.

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Nonperforming Assets.  At March 31, 2017, nonperforming assets totaled $4.3 million, or 0.8% of total assets, compared to $4.5 million, or 0.8% of total assets, at December 31, 2016.

The table below sets forth the amounts and categories of nonperforming assets at the dates indicated (dollars in thousands):

	Nonperforming Assets
	March 31, 2017		December 31, 2016		Amount Change			Percent Change
Nonaccrual loans	$	1,922	$	3,144	$	(1,223	)		(38.9	)%
Nonperforming TDRs		1,455		205		1,251			610.2
Total nonperforming loans		3,377		3,349		28			0.8
OREO and repossessed assets		952		1,172		(220	)		(18.8	)
Total nonperforming assets	$	4,329	$	4,521	$	(192	)		(4.2	)

Nonperforming loans, consisting of nonaccrual loans and nonperforming TDRs, increased $28,000 to $3.4 million or 0.69% of total gross loans at March 31, 2017 from $3.3 million or 0.67% of total gross loans at December 31, 2016, primarily due to an increase in nonperforming TDRs.   Our largest nonperforming loan at March 31, 2017 was a $1.3 million one-to-four-family residential loan located in King County, Washington.

OREO and repossessed assets decreased $220,000, or 18.8% to $952,000 from $1.2 million during the three months ended March 31, 2017, due to the sale of two one- to four-family residential properties totaling $220,000.  The net gain on sale for these two properties totaled $3,000.  At March 31, 2017, our largest OREO property was a commercial building with a recorded value of $600,000 located in Clallam County, Washington, which was acquired in 2015 as a part of three branches purchased from another financial institution.  Our next largest OREO properties were a $342,000 one- to four- family property located in Suffolk County, New York, and a $10,000 manufactured home located in King County, Washington.  The former bank branch property originally was classified as a fixed asset and was subsequently reclassified to OREO in 2016.  It is currently leased to a not for profit organization headquartered in our market area at a below market rate.  The property in Suffolk County, New York was a repurchase of a loan from the portfolio of mortgage servicing rights we acquired in 2009.

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 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.

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The following table reflects the adjustments in our allowance for loan losses during the periods indicated (dollars in thousands):

	Three Months Ended March 31,
	2017			2016
Balance at beginning of period	$	4,822		$	4,636
Charge-offs		(29	)		(83	)
Recoveries:		45			6
Net (charge-offs)/recoveries		16			(77	)
Provisions charged to operations		-			150
Balance at end of period	$	4,838		$	4,709
Ratio of net charge-offs/(recoveries) during the period to average loans outstanding during the period		(0.1	)%		0.07	%
	March 31, 2017			December 31, 2016
Allowance as a percentage of nonperforming loans (end of period)		143.26	%		143.98	%
Allowance as a percentage of total loans (end of period)		0.99	%		0.96	%

Our allowance for loan losses at March 31, 2017 was $4.8 million, which represents 0.99% of total loans receivable compared to 0.96% at December 31, 2016.  The increase in the allowance for loan losses at March 31, 2017, compared to the prior quarter was due to net recoveries totaling $16,000 received during the first quarter of 2017 compared to net charge-offs of $241,000 for the quarter ended December 31, 2016, partially offset by a $204,000 provision taken in the fourth quarter of 2016.  No provision for loan losses was recorded in the first quarter of 2017 as total nonperforming loans remained relatively flat at $3.4 million as of March 31, 2017 compared to $3.3 million at December 31, 2016 and total average loans remained stable at $495.6 million compared to $494.5 million.

Specific loan loss reserves increased $104,000 at March 31, 2017 compared to December 31, 2016, while general loan loss reserves decreased $88,000 at March 31, 2017, compared to December 31, 2016.  The increase in specific loan loss reserves was primarily due to an increase in impaired loans during the current period. There were 14 loans which were reported as impaired as of March 31, 2017 which were not impaired as of December 31, 2016. These loans included five one- to four- family residential loans, three home equity loans, three commercial loans, two commercial multifamily loans, and one consumer loan. Partially offsetting this increase in impaired loans were four loans that were reported as impaired as of December 31, 2016 which were not impaired as of March 31, 2017. These loans consisted of two manufactured home loans, one commercial and industrial loan and a one- to four-family residential loan. The three largest impaired loans at March 31, 2017 were two one- to four- family residential loans totaling $2.6 million which were newly impaired loans during the first quarter of 2017 and a $763,000 loan secured by a commercial building, all located in King County, Washington.  Net recoveries for the three months ended March 31, 2017 were $16,000, or 0.01%, of average loans on an annualized basis, compared to net charge-offs of $77,000 or 0.07% of average loans for the same period in 2016.  As of March 31, 2017, the allowance for loan losses as a percentage of total loans receivable and nonperforming loans was 0.99% and 143.26%, respectively, compared to 0.96% and 143.98%,respectively, at December 31, 2016.

Deposits.  Total deposits increased by $13.1 million, or 2.8%, to $480.8 million at March 31, 2017 from $467.7 million at December 31, 2016, primarily as a result of a $7.5 million, or 5.0%, increase in interest-bearing demand accounts, a $7.9 million, or 12.4% increase in noninterest-bearing demand accounts (including escrow accounts), and a $3.0 million, or 6.6%, increase in savings accounts.  The increases in these deposit accounts reflect our continuing emphasis on developing relationships with retail and small business customers.  These increases were partially offset by a $7.0 million, or 4.4%, decrease in time deposit accounts.  The decrease in time deposits was due in part to a decrease in public fund certificates, which decreased by $11.6 million during the quarter due to these time deposits reaching their maturity dates and management choosing not to renew these higher cost deposits.  At March 31, 2017, brokered deposits were $2.9 million compared to $3.6 million at December 31, 2016.

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A summary of deposit accounts with the corresponding weighted average cost of funds is presented below (dollars in thousands):

	March 31, 2017					December 31, 2016
	Amount		Wtd. Avg. Rate			Amount		Wtd. Avg. Rate
Noninterest-bearing demand	$	67,861		0.00	%	$	60,566		0.00	%
Interest-bearing demand		157,871		0.35			150,327		0.34
Savings		47,840		0.20			44,879		0.22
Money market		50,773		0.19			49,042		0.17
Time deposits		152,707		1.34			159,742		1.12
Escrow(1)		3,770		0.00			3,175		0.00
Total deposits	$	480,822		0.60		$	467,731		0.53

 ⁽¹⁾ Escrow balances shown in noninterest-bearing deposits on the consolidated balance sheets

Borrowings.  FHLB advances decreased $29.2 million, or 53.2%, to $25.6 million at March 31, 2017, with a weighted-average cost of 1.07%, from $54.8 million at December 31, 2016, with a weighted-average cost of 0.82%.  The increase in the average rate was due to an increase in the overnight borrowing rate in the current period compared to the three months ended December 31, 2016reflecting the recent increase in the federal funds rate.  Excess funds from increased deposits and loan repayments during the quarter ended March 31, 2017 were used to reduce borrowings.  We rely on FHLB advances to fund interest-earning assets when deposits alone cannot fully fund interest-earning asset growth.  This reliance on borrowings, rather than deposits, may increase our overall cost of funds.

Stockholders’ Equity.  Total stockholders’ equity increased $1.4 million, or 2.2%, to $61.6 million at March 31, 2017 from $60.3 million at December 31, 2016.  This increase primarily reflects $1.4 million in net income and share-based compensation of $144,000, partially offset by the payment of a cash dividend of $250,000 to common stockholders during the current quarter.

Comparison of Results of Operation for the Three Months Ended March 31, 2017 and 2016

General.  Net income increased $308,000 to $1.4 million, or $0.54 per diluted common share, for the three months ended March 31, 2017, compared to $1.1 million, or $0.43 per diluted common share, for the three months ended March 31, 2016.  The primary reasons for the increase in net income were increases in net interest income and noninterest income and a decrease in the provision for loan losses, partially offset by an increase in noninterest expense.  Net interest income increased primarily as a result of higher average loan balances and slightly higher average yields on loans in the current period compared to a year ago.  The provision for loan losses decreased due to a decrease in net charge-offs and impaired loans for the quarter as compared to a year ago.  The increase in noninterest income was primarily the result of an improvement in the fair value adjustment on mortgage servicing rights, an increase in mortgage servicing income, partially offset by declines in service charges and fee income and gain on sale of loans.  Noninterest expense was higher primarily as a result of increases in salaries and benefits, and operating costs partially offset by a decrease in regulatory assessments.

Interest Income.  Interest income increased by $524,000, or 8.6%, to $6.6 million for the three months ended March 31, 2017, from $6.1 million for the three months ended March 31, 2016.  The increase in interest income primarily reflected an increase in average loan balances and a slightly higher average yield on loans.

Our weighted average yield on interest-earning assets was 4.87% for the three months ended March 31, 2017, compared to 4.85% for the three months ended March 31, 2016.  The weighted average yield on loans increased to 5.20% for the three months ended March 31, 2017 from 5.18% for the three months ended March 31, 2016 due to higher average loan balances and higher average yields on loans.  The average balance of gross loans receivable increased $35.9 million, or 7.8%, for the three months ended March 31, 2017, as compared to the same period last year.  The weighted average yield on available-for-sale securities and interest bearing cash was 1.20% for the three months ended March 31, 2017, compared to 1.08% for the three months ended March 31, 2016.  The average balance of the investment portfolio, which included interest-bearing cash balances and available-for-sale securities increased $6.8 million, or 15.8%.  The overall average yield on the investment portfolio increased 12 basis points due to the increase in rates paid on overnight deposits as a result of the recent increase in the Fed Funds rate.

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Interest Expense.  Interest expense increased $78,000 or 10.9%, to $795,000 for the three months ended March 31, 2017, from $717,000 for the three months ended March 31, 2016.  This increase was primarily the result of a $17.6 million, or 3.9%, increase in the average balance of deposits and a $19.4 million, or 86.0%, increase in the average balance of FHLB advances for the three months ended March 31, 2017, as compared to the same period last year.  Our weighted average cost of interest-bearing liabilities was 0.71% for the three months ended March 31, 2017, compared to 0.68% for the same period last year.

Interest paid on deposits increased $15,000, or 2.2%, to $703,000 for the three months ended March 31, 2017, from $688,000 for the three months ended March 31, 2016.  This increase resulted from the higher average balance of deposits outstanding in the period compared to a year ago.  Our weighted average cost of deposits during the three months ended March 31, 2017 was 0.60%, as compared to 0.61% during the three months ended March 31, 2016.

Interest expense on borrowings, which consisted solely of advances from the FHLB, increased $63,000, or 217.2%, to $92,000 for the three months ended March 31, 2017, from $29,000 for the three months ended March 31, 2016.  The increase was the result of higher overnight borrowing rates during the quarter as compared to a year ago reflecting recent increases in the federal funds rate, as well as a higher average outstanding balance of FHLB advances. Our average cost of FHLB advances was 0.88% for the three months ended March 31, 2017, compared to 0.52% for the three months ended March 31, 2016. The average outstanding balance of FHLB advances increased $19.4 million, or 86.0%, to $41.9 million at March 31, 2017, from $22.5 million at March 31, 2016.

Net Interest Income.  Net interest income increased $446,000, or 8.3%, to $5.8 million for the three months ended March 31, 2017, from $5.4 million for the three months ended March 31, 2016.  The increase resulted from increased interest income due to higher average loan balances and slightly higher average yields on loans, partially offset by higher interest expense.  Our net interest margin increased slightly to 4.28% for the three months ended March 31, 2017, compared to 4.27% for the three months ended March 31, 2016due primarily to higher average loan balances and loan yields reflecting the increase in the amount of higher yielding nonresidential loans in our portfolio.

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

There was no provision for loan losses recorded for the three months ended March 31, 2017, compared to a provision of $150,000 for the three months ended March 31, 2016.  The absence of a provision for loan losses compared to the same period a year ago was primarily a result of a reduction in impaired loans and charge-offs.  At March 31, 2017, impaired loans totaled $10.4 million compared to $12.3 million at March 31, 2016.  There were nineteen loans totaling $5.6 million, which were reported as impaired as of March 31, 2016 which were not impaired as of March 31, 2017, and twenty-one loans totaling $4.0 million that were newly classified as impaired at March 31, 2017 as compared to March 31, 2016.

For the three months ended March 31, 2017, our percentage of net (charge-offs)/recoveries during the period to average loans outstanding during the period was a net recovery of 0.01% (annualized), compared to net charge-offs of 0.07% (annualized) for the three months ended March 31, 2016.  Total impaired loans increased $2.2 million, or 26.8% to $10.4 million from $8.2 million at December 31, 2016.  The percentage of nonperforming loans to total loans increased two basis points to 0.69% at March 31, 2017 from 0.67% at December 31, 2016.

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While we believe the estimates and assumptions used in our determination of the adequacy of the allowance are reasonable, there can be no assurance that such estimates and assumptions will not be proven incorrect in the future, or that the actual amount of future provisions will not exceed the amount of past provisions or that any increased provisions that may be required will not adversely impact our financial condition and results of operations.  In addition, the determination of the amount of our allowance for loan losses is subject to review by bank regulators as part of the routine examination process, which may result in the adjustment of reserves based upon their judgment of information available to them at the time of their examination.

Noninterest Income.  Noninterest income decreased $46,000, or 4.8%, to $996,000 for the three months ended March 31, 2017, as compared to $950,000 for the three months ended March 31, 2016 as reflected below (dollars in thousands):

	Three Months Ended March 31,						Amount			Percent
	2017			2016			Change			Change
Service charges and fee income	$	511		$	566		$	(55	)		(9.7	)%
Earnings on cash surrender value of BOLI		81			84			(3	)		(3.6	)
Mortgage servicing income		253			204			49			24.0
Fair value adjustment on mortgage servicing rights		(20	)		(114	)		94			(82.5	)
Net gain on sale of loans		171			210			(39	)		(18.6	)
Total noninterest income	$	996		$	950		$	46			4.8

The increase in noninterest income compared to the year ago quarter was primarily a result of a $94,000 improvement in the fair value adjustment on mortgage servicing rights to a negative $20,000 fair value adjustment for the current quarter from a negative $114,000 for the quarter ended March 31, 2016 and a $49,000 increase in mortgage servicing income, partially offset by declines in service charges and fee income and gain on sale of loans of $55,000 and $39,000, respectively.  The improvement in the fair value adjustment on mortgage servicing rights was a result of normal fluctuations in the pricing of this asset based on prepayment speeds and expected cash flows from this asset.  The increase in mortgage servicing income was due to higher mortgage interest rates in the first quarter of 2017 as compared to the same period last year.  Service charges and fee income decreased primarily due to lower loan fees reflecting lower loan originations.  Lower gains on the sale of loans were due to fewer loan originations reflecting reduced refinance activity in the first quarter of 2017 as compared to the same period last year.

Noninterest Expense.  Noninterest expense increased $158,000, or 3.5%, to $4.6 million during the three months ended March 31, 2017 as compared to $4.5 million during the three months ended March 31, 2016, as reflected below (dollars in thousands):

	Three Months Ended March 31,				Amount			Percent
	2017		2016		Change			Change
Salaries and benefits	$	2,691	$	2,563	$	128			5.0	%
Operations		1,021		972		49			5.0
Regulatory assessments		124		155		(31	)		(20.0	)
Occupancy		373		385		(12	)		(3.1	)
Data processing		407		386		21			5.4
Losses and expenses on OREO and repossessed assets		3		-		3		NM
Total noninterest expense	$	4,619	$	4,461	$	158			3.5

NM – Not meaningful.

Noninterest expense was higher primarily as a result of higher salaries and benefitsdue to an increase in full time equivalent employees, and operations expenses.  These expenses werepartially offset by lower regulatory and occupancy expenses. The increase in operations expense was primarily due to an increase in debit card activity.

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Income Tax Expense.   For the three months ended March 31, 2017, we incurred income tax expense of $760,000 on our pre-tax income as compared to $584,000 for the three months ended March 31, 2016.  The effective tax rates for the three months ended March 31, 2017 and 2016 were 35.0% and 34.6%, respectively.

Liquidity

The Management Discussion and Analysis in Item 7 of the Company’s 2016 Form 10-K 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, 2017.

The Bank’s primary sources of funds are deposits, principal and interest payments on loans and borrowings.  While maturities and scheduled amortization of loans are a predictable source of funds, deposit flows and loan prepayments are greatly influenced by general interest rates, economic conditions and competition.  The Bank’s primary investing activity is loan originations.  The Bank maintains liquidity levels it believes to be adequate to fund loan commitments, investment opportunities, deposit withdrawals and other financial commitments.  At March 31, 2017 the Bank had $59.2 million in cash and cash equivalents and available for sale securities, and $2.0 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 $164.1 million from the FHLB, $41.8 million through the Federal Reserve’s Discount Window, $9.0 million through a Fed Funds line at Zions Bank, $2.0 million through a Fed Funds line at Pacific Coast Banker’s Bank and $10.0 million through an unsecured line of credit with The Independent 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, 2017, outstanding loan commitments, including unused lines and letters of credit totaled $62.8 million.  Certificates of deposit scheduled to mature in one year or less at March 31, 2017, totaled $58.3 million.  Based on our competitive pricing and historical experience, we believe that a majority of maturing deposits will remain with the Bank.

Cash and cash equivalents decreased $1.8 million to $52.8 million as of March 31, 2017, from $54.6 million as of December 31, 2016.  Net cash provided by operating activities was $2.3 million for the three months ended March 31, 2017.  Net cash of $11.7 million was provided by investing activities during the three months ended March 31, 2017 and consisted primarily of a decrease in net loans.  The $15.8 million of cash used in financing activities during the three months ended March 31, 2017 was primarily the net result of a $29.2 million net decrease in FHLB borrowings, partially offset by an increase of $13.1 million in deposits.

As a separate legal entity from the Bank, the Company must provide for its own liquidity.  At March 31, 2017, the Company, on an unconsolidated basis, had $1.7 million in cash, noninterest-bearing deposits and liquid investments generally available for its cash needs.  The Company’s principal source of liquidity is dividends and ESOP loan repayments 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, we engage 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.  For the three months ended March 31, 2017, we engaged in no off-balance sheet transactions likely to have a material effect on our financial condition, results of operations or cash flows.

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A summary of our off-balance sheet loan commitments at March 31, 2017 is as follows (in thousands):

	March 31, 2017
Residential mortgage commitments	$	5,699
Undisbursed portion of loans originated		31,692
Unused lines of credit		25,187
Irrevocable letters of credit		185
Total loan commitments	$	62,763

Capital

Sound Community Bank is subject to minimum capital requirements imposed by regulations of the FDIC.  Capital adequacy requirements are quantitative measures established by regulation that require Sound Community Bank to maintain minimum amounts and ratios of capital.

Based on its capital levels at March 31, 2017, Sound Community Bank exceeded all regulatory capital 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 FDIC.  Based on capital levels at March 31, 2017, Sound Community Bank was considered to be well-capitalized under applicable regulatory requirements.  Management monitors the capital levels to provide for current and future business opportunities and to maintain Sound Community Bank’s “well-capitalized” status.

The actual regulatory capital amounts and ratios calculated for Sound Community Bank at March 31, 2017 were as follows (dollars in thousands):

	Actual					Minimum For Capital Adequacy Purposes					To Be Well Capitalized Under Prompt Corrective Action Provisions
	Amount		Ratio			Amount		Ratio			Amount		Ratio
March 31, 2017
Tier 1 Capital to average assets	$	59,117		10.25	%	$	23,063		>4.0	%	$	28,829		>5.0	%
Common Equity Tier 1 (“CET1”) risk-based capital ratio		59,117		12.58			21,147		>4.5	%		30,545		>6.5	%
Tier 1 Capital to risk-weighted assets		59,117		12.58			28,195		>6.0	%		37,594		>8.0	%
Total Capital to risk-weighted assets		64,150		13.65			37,594		>8.0	%		46,992		>10.0	%

Pursuant to the capital regulations of the FDIC and the other federal banking agencies, the Bank must maintain a capital conservation buffer consisting of additional CET1 capital greater than 2.5% of risk-weighted assets above the required minimum levels of risk-based CET1 capital, tier 1 capital and total capital in order to avoid limitations on paying dividends, repurchasing shares, and paying discretionary bonuses.  For our fiscal year ending December 31, 2017, the capital conservation buffer rule requires a buffer of greater than 1.25% of risk-weighted assets, which amount will increase by 0.625% yearly until the requirement is fully phased-in on January 1, 2019, when the buffer must exceed 2.5% of risk-weighted assets.  As March 31, 2017, the Bank’s CET1 capital exceeded the required capital conservation buffer.

For a bank holding company with less than $1.0 billion in assets, the capital guidelines apply on a bank only basis and the Federal Reserve expects the holding company’s subsidiary banks to be well capitalized under the prompt corrective action regulations.  If Sound Financial Bancorp was subject to regulatory guidelines for bank holding companies with $1.0 billion or more in assets, at March 31, 2017 Sound Financial Bancorp would have exceeded all regulatory capital requirements.  The estimated regulatory capital ratios calculated for Sound Financial Bancorp as of March 31, 2017 were 10.64% for Tier 1 leverage-based capital, 13.05% for both Common Equity Tier 1 risk-based capital, Tier 1 Capital to risk-based assets and 14.12% for total risk-based capital.

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Item 3. Quantitative and Qualitative Disclosures About Market Risk

The Company provided information about market risk in Item 7A of its 2016 Form 10-K.  There have been no material changes in our market risk since our 2016 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, 2017, 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, 2017, 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 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 errors 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 errors or mistakes. 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 three months ended March 31, 2017, that have materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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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)  Not applicable

(b)  Not applicable

(c)  There were no repurchases of the Company’s common stock during the three months ended March 31, 2017.

Item 3 Defaults Upon Senior Securities

Nothing to report.

Item 4 Mine Safety Disclosures

Not Applicable

Item 5. Other Information

Nothing to report.

Item 6. Exhibits

Exhibits:
3.1	Articles of Incorporation of Sound Financial Bancorp, Inc. (incorporated herein by reference to the Registration Statement on Form S-1 filed with the SEC on March 27, 2012 (File No. 333-180385))
3.2	Bylaws of Sound Financial Bancorp, Inc. (incorporated herein by reference to the Registration Statement on Form S-1 filed with the SEC on March 27, 2012 (File No. 333-180385))
4.0	Form of Common Stock Certificate of Sound Financial Bancorp, Inc. (incorporated herein by reference to the Registration Statement on Form S-1 filed with the SEC on March 27, 2012 (File No. 333-180385))
10.1	Form of Amended and Restated Employment Agreement dated August 30, 2016, among Sound Financial Bancorp, Inc., Sound Community Bank and Laura Lee Stewart (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on September 1, 2016 (File No. 001-35633))
10.2	Amended and Restated Supplemental Executive Retirement Agreement 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 November 27, 2015 (File No. 001-35633))
10.3	Amended and Restated Long Term Compensation Agreement 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 November 27, 2015 (File No. 001-35633))
10.4	Amended and Restated Confidentiality, Non-Competition and Non-Solicitation Agreement 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 November 27, 2015 (File No. 001-35633))

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10.5	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))
10.6	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))
10.7	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))
10.8	2013 Equity Inventive Plan (included as Exhibit 10.13 to the Registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30,2013 and incorporated herein by reference (File No. 001-35633))
10.9	Form of Incentive Stock Option Agreement, Non-Qualified Stock Option Agreement and Restricted Stock Agreement under the 2013 Equity Incentive Plan (included as Exhibit 10.14 to the Registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2013 and incorporated herein by reference (File No. 001-35633))
10.10	Amended and Restated Change of Control Agreement dated June 21, 2016, by and among Sound Financial Bancorp, Inc., Sound Community Bank and Matthew P. Deines (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on June 24, 2016 (File No. 001-35633))
10.11	Change of Control Agreement dated June 21, 2016, by and among Sound Financial Bancorp, Inc., Sound Community Bank and Elliott Pierce
10.12	Adoption Agreement for the Sound Community Bank Nonqualified Deferred Compensation Plan (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on March 24, 2017 (File No. (0001140361-17-013082))
10.13	The Sound Community Bank Nonqualified Deferred Compensation Plan (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on May 16, 2016 (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on March 24, 2017 (File No. (0001140361-17-013082))
11	Statement re computation of per share earnings (See Note 9 of the Notes to Condensed Consolidated Financial Statements contained in Item 1, Part I of this Current 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

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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 Financial Bancorp, Inc.
Date: May 12, 2017	By:	/s/  Laura Lee Stewart
		Laura Lee Stewart
		President and Chief Executive Officer
Date:  May 12, 2017	By:	/s/  Matthew P. Deines
		Matthew P. Deines
		Executive Vice President and Chief Financial Officer

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EXHIBIT INDEX

Exhibit No.
10.11	Change of Control Agreement dated June 21, 2016, by and among Sound Financial Bancorp, Inc., Sound Community Bank and Elliott Pierce
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

45