The following discussion is intended to assist in understanding the financial condition and results of operations of the Corporation and its subsidiaries. The information contained in this section should be read in conjunction with the Consolidated Financial Statements and the accompanying Notes contained herein.

Forward Looking Statements

Management's Discussion and Analysis of Financial Condition and Results of Operations and this Form 10-Q contain certain forward-looking statements which are based on assumptions and describe future plans, strategies and expectations of the Corporation. Management desires to take advantage of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and is including this statement for the express purpose of availing the Corporation of the protections of the safe harbor with respect to all forward-looking statements in this Form 10-Q. These forward-looking statements are generally identified by use of the word "believe," "expect," "intend," "anticipate," "estimate," "project," or similar words. The Corporation's ability to predict results of the actual effect of future plans or strategies is uncertain. Factors which could cause actual results to differ materially include, but are not limited to, the credit risks of lending activities, including changes in the level and trend of loan delinquencies and write-offs; changes in general economic conditions, either nationally or in our market areas; changes in the levels of general interest rates, deposit interest rates, our net interest margin and funding sources; fluctuations in the demand for loans, the number of unsold homes and other properties and fluctuations in real estate values in our market areas; results of examinations of us by the Federal Reserve and our savings bank subsidiary by the Federal Deposit Insurance Corporation, the Washington Department of Financial Institutions or other regulatory authorities, including the possibility that any such regulatory authority may, among other things, impose restrictions on our operations or require us to increase our reserve for loan losses or to write-down assets; our ability to control operating costs and expenses; our ability to successfully integrate any assets, liabilities, customers, systems, and management personnel we have acquired or may in the future acquire into our operations and our ability to realize related revenue synergies and cost savings within expected time frames and any goodwill charges related thereto; our ability to manage loan delinquency rates and dispose of real estate we may acquire as a result of loan foreclosures; our ability to retain key members of our senior management team; costs and effects of litigation, including settlements and judgments; increased competitive pressures among financial services companies; changes in consumer spending, borrowing and savings habits; legislative or regulatory changes that adversely affect our business; adverse changes in the securities markets; 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; war or terrorist activities; other economic, competitive, governmental, regulatory, and technological factors affecting our operations, pricing, products and services and other risks detailed in the Corporation's reports filed with the Securities and Exchange Commission, including the Annual Report on Form 10-K for the fiscal year ended March 31, 2008. The Corporation undertakes no responsibility to update or revise any forward-looking statements. These risks and uncertainties should be considered in evaluating forward-looking statements and you should not rely too much on these statements.

General

Horizon Financial was formed under Washington law on May 22, 1995, and became the holding company for Horizon Bank effective October 13, 1995. At December 31, 2008, Horizon Financial had total assets of $1.47 billion, total deposits of $1.20 billion and total equity of $118.3 million. The Corporation's business activities generally are limited to passive investment activities and oversight of its investment in the Bank. Accordingly, the information set forth in this report, including consolidated financial statements and related data, relates primarily to the Bank and its subsidiary.

The Bank (a subsidiary of Horizon Financial) was organized in 1922 as a Washington State chartered mutual savings and loan association and converted to a federal mutual savings and loan association in 1934. In 1979, the Bank converted to a Washington State chartered mutual savings bank. On August 12, 1986, the Bank converted to a state chartered stock savings bank under the name "Horizon Bank, a savings bank". The Bank became a member of the Federal Home Loan Bank ("FHLB") of Seattle in December 1998. Effective March 1, 2000, the Bank changed its name to its current name, "Horizon Bank". Effective August 1, 2005, the Bank converted from a state chartered savings bank to a state chartered commercial bank. The Bank's deposits are insured by the Federal Deposit Insurance Corporation ("FDIC") up to applicable limits.

The Corporation's results of operations depend primarily on revenue generated as a result of its net interest income and noninterest income. Net interest income is the difference between the interest income the Corporation earns on its interest-earning assets (consisting primarily of loans and investments securities) and the interest the Corporation pays on its interest-

bearing liabilities (consisting primarily of customer savings and money market accounts, time deposits and borrowings). Noninterest income consists primarily of service charges on deposit and loan accounts, gains on the sale of loans and investments, and loan servicing fees. The Corporation's results of operations are also affected by its provisions for loan losses and other expenses. Other expenses consist primarily of noninterest expense, including compensation and benefits, occupancy, equipment, data processing, marketing, automated teller machine costs and, when applicable, deposit insurance premiums. The Corporation's results of operations may also be affected significantly by general and local economic and competitive conditions, changes in market interest rates, governmental policies and actions of regulatory authorities, as well as other factors identified under the caption "Forward Looking Statements" above.

Business Strategy

The Corporation's business strategy is to operate Horizon Bank as a well-capitalized, profitable and independent community bank, dedicated to a diversified base of commercial lending, home mortgage lending, consumer lending, small business lending and providing quality financial services to local personal and business customers. The Corporation has sought to implement this strategy by: (i) focusing on commercial banking opportunities;
(ii) continuing efforts towards the origination of residential mortgage loans, focusing on loans eligible for sale in the secondary market; (iii) providing high quality, personalized financial services to individuals and business customers and communities served by its branch network; (iv) selling many of its fixed rate mortgages to the secondary market; (v) focusing on asset quality; (vi) containing operating expenses; and (vii) maintaining capital in excess of regulatory requirements combined with prudent growth. In the past, this strategy included a focus on residential construction and development lending; however this is not part of the future strategy of the Corporation, as the focus now is on diversifying the balance sheet and decreasing its concentration in this area.

As a result of the downturn in the economy and the net losses realized for the three and nine months ended December 31, 2008, the Bank's efforts are focused primarily on improving asset quality, capital preservation, expense reduction, managing liquidity and core deposit growth. Beginning with the quarter ended September 30, 2008, the Bank expanded its special assets team which is responsible for working out problem assets which have grown substantially over the past six months, by shifting personnel within the Corporation.. The Bank has continued to focus on core deposit growth to enhance its liquidity position. At December 31, 2008, the Bank's core deposits increased $24.0 million, or 3.8% to $654.5 million from $630.5 million at March 31, 2008, as shown in the table later in this document illustrating an analysis of the deposit portfolio by major type of deposit. In addition, the Bank has performed an extensive review of potential expense reductions. In evaluating the controllable expenses, the Bank determined the need to make several strategic staffing reductions. As of November 4, 2008, the Bank completed a reduction in force of 27 full-time positions at the Bank, and also identified several areas where responsibilities will be shifted to accommodate the revised staffing levels. In the weeks leading up to the November 4, 2008 strategic staffing reduction, other positions were not filled when vacated by the employees previously occupying these positions These reductions in personnel, along with strategic reductions in other noninterest expense areas are expected to result in over $3 million in expense savings on an annual basis. In connection with the reduction in personnel, the Company incurred approximately $135,000 in severance related expenses during the quarter ended December 31, 2008.

Operating Strategy

The Corporation serves as a holding company for the Bank, providing strategic oversight, management, access to capital and other resources and activities typically performed by bank holding companies. The Bank currently has two offices in Pierce County (south of King County), with the remaining offices all located north of King County.

The primary business of the Bank is to acquire funds in the form of deposits gathered from our retail branches and to use the funds to make commercial, consumer, and real estate loans in its primary market area. In addition, and to a lesser extent, the Bank invests in a variety of investment grade securities including, but not necessarily limited to U.S. Government and federal agency obligations, mortgage-backed securities, corporate debt, equity securities, and municipal securities. The Bank intends to reduce its reliance on FHLB advances, brokered deposits, and other wholesale borrowings from its current levels as it focuses on deleveraging its balance sheet.

The Corporation's profitability depends primarily on its net interest income, which is the difference between the income it receives on the Bank's loan and investment portfolio and the Bank's cost of funds, which consists of interest paid on deposits and borrowings. The Bank reviews its opportunities with respect to both assets and liabilities. In recent years, for example, the Bank chose to concentrate its commercial lending efforts on growing its Prime-based loan portfolio, at a time when some lenders were offering fixed rate real estate loans at sub-Prime rates. In this regard, the Bank's loan portfolio growth is heavily concentrated in the real estate development and construction markets in the Puget Sound region. Through its relationships with established real estate developers and builders, the Bank's loan officers increased this portion of the Bank's portfolio, which is primarily Prime-based business. With the Federal Reserve Board's Federal Open Market Committee's ("FOMC") 400 basis point reductions from December 2007 through December 2008, the Corporation is experiencing a decline

in its net interest margin. This rapid pace of easing monetary policy by the FOMC will contribute to further declines in the Corporation's net interest margin. On the liability side of the balance sheet, these changing rates also impact the Bank's earnings. Management acknowledges that there is a lag effect in this regard, in both increasing and decreasing rate environments as the rates on the Bank's certificate of deposit liabilities do not adjust instantly, rather the impact occurs more gradually than the impact on its assets, as certificates of deposit mature and reprice in a changing interest rate environment.

Net interest income is also affected by the relative amounts of interest-earning assets and interest-bearing liabilities. When interest-earning assets equal or exceed interest-bearing liabilities, any positive interest rate spread will generate net interest income. The Corporation's profitability is also affected by the level of the Bank's other income and expenses. Other noninterest income includes income associated with the origination and sale of mortgage loans, loan servicing fees, deposit account related fees, and net gains and losses on sales of interest-earning assets. This portion of the Bank's income is heavily dependent on the Bank's success at originating and selling one-to-four family mortgage loans into the secondary market. Recently the Bank's mortgage banking activity has declined commensurate with the slowdown in the housing industry. In addition, the Bank's ability to generate fee income on its deposit accounts impacts this portion of the Bank's income stream.

Other noninterest expenses include compensation and benefits, occupancy and equipment expenses, deposit insurance premiums, data servicing expenses and other operating costs.

Finally, the Corporation's results of operations are also significantly affected by general economic and competitive conditions, particularly loan delinquencies, changes in market interest rates, conditions in the financial services industry, government legislation, regulation, and monetary and fiscal policies. In the Corporation's primary market areas, there have been an increasing number of adverse employment announcements. In late January 2008, it was reported that Boeing intends to layoff 10,000 employees, representing approximately 6% of its workforce. In addition, Microsoft announced its intention to cut 5,000 employees from its payrolls, and Starbucks announced they would be laying off 7,000 workers and closing 300 stores worldwide. These adverse employment reports followed reports from the Washington State Employment Security Department which showed unemployment levels higher in December 2008 in each of the Corporation's markets (compared to December 2007 levels). These reports lead management to the conclusion that the challenges being faced in the housing markets are not likely to improve in the near future.

Financial Condition

Total consolidated assets for the Corporation at December 31, 2008, increased to $1.47 billion or 5.8% from $1.39 billion at March 31, 2008. This increase in assets was primarily a result of the growth in interest bearing deposits, which increased $77.9 million to $80.9 million at December 31, 2008 from $2.9 million at March 31, 2008. The increase in interest bearing deposits was a result of the strategy to enhance the Bank's liquidity position, accomplished in part by utilizing brokered deposits and by paying above average retail deposit rates in our local markets. Net loans receivable was relatively unchanged at $1.19 billion as of December 31, 2008 and March 31, 2008. The decrease in net loans receivable was attributable to a combination of factors, including a $39.6 million decrease in commercial construction loans as the Bank worked to decrease its balances in this business line. Commercial construction includes commercial speculative one-to-four family (large one-to-four family developments and condominium projects), multifamily and commercial buildings as shown in the construction and land development table later in this section. During the period, the commercial business loan category increased $31.4 million, or 17.7% as the Bank continues to focus on increasing its commercial lines of credit balances in order to diversify its loan portfolio and expand its relationships with businesses in its markets. One-to-four family mortgage loans, net of participations sold, increased 5.1% to $154.3 million at December 31, 2008 from $146.9 million at March 31, 2008. The Bank implemented a key lending program to help the Bank's commercial builder/developers sell inventory, which focused on offering special mortgages to prospective home buyers. The Bank had net sales of $37.4 million of real estate loans during the nine months ended December 31, 2008, compared to $59.2 million during the nine months ended December 31, 2007 as a result of a slowdown in the overall real estate market.

The following is an analysis of the loan portfolio by major loan categories:

                                 December 31,    % of     March 31,    % of
(Dollars in thousands)              2008       Portfolio    2008     Portfolio
                                 -----------   ---------  --------   ---------
One-to-four family mortgage loans
  One-to-four family               $167,737      13.8%   $  165,824     13.7%
  One-to-four family construction    35,500       2.9%       35,303      2.9%
  Less participations sold          (48,943)     (4.0)%     (54,269)    (4.5)%
                                   --------      ----      --------      ----
    Net one-to-four family
     mortgage loans                 154,294      12.7%      146,858     12.1%

16




  Commercial land development       201,683      16.6%      183,827     15.2%
  Commercial construction (1)       263,113      21.7%      302,708     25.0%
  Multifamily residential            42,722       3.5%       45,049      3.7%
  Commercial real estate            273,906      22.6%      300,109     24.8%
  Commercial business loans         209,072      17.3%      177,685     14.7%
  Home equity secured                59,538       4.9%       47,351      3.9%
  Other consumer loans                8,151        .7%        7,005       .6%
                                 ----------     -----    ----------     ----
        Subtotal                  1,058,185      87.3%    1,063,734     87.9%
                                 ----------     -----    ----------     ----
  Total loans receivable          1,212,479     100.0%    1,210,592    100.0%
                                 ----------     -----    ----------     ----
Less:
    Allowance for loan losses       (25,309)                (19,114)
                                 ----------              ----------
    Net loans receivable         $1,187,170              $1,191,478
                                 ==========              ==========


                                 December 31,    % of     March 31,    % of
  (Dollars in thousands)            2008       Portfolio    2008     Portfolio
                                 -----------   ---------  --------   ---------

  Net residential loans          $  152,502      12.8%   $  145,565     12.2%
  Net commercial business loans     203,760      17.2%      174,263     14.6%
  Net commercial real estate
   loans (2)                        764,714      64.4%      818,215     68.7%
  Net consumer loans (3)             66,194       5.6%       53,435      4.5%
                                 ----------     -----    ----------     ----
                                 $1,187,470     100.0%   $1,191,478      100%
                                 ==========     =====    ==========     ====

(1) Includes $37.3 million and $54.6 million in condominium construction projects at December 31, 2008 and March 31, 2008, respectively.
(2) Includes construction and development, multi-family and commercial real estate loans.
(3) Includes home equity and other consumer loans.

As reflected in the table above, approximately 64.4% of our total net loan portfolio consists of commercial and multifamily real estate and construction and land development loans. Management has made the strategic decision to reduce the level of exposure to these types of loans during the economic slowdown and has dramatically reduced its lending to this type of borrower. Management intends to continue these efforts to reduce its concentration in construction and land development loans. These loans are typically greater in amount, more difficult to evaluate and monitor and, therefore, involve a greater degree of complexity and risk than single family residential mortgage loans. Because payments on loans secured by commercial and multifamily real estate often depend upon the successful operation and management of the properties, repayment of such loans are being challenged at this time by adverse conditions in the real estate market and our local economy. The Bank seeks to reduce these risks by reducing the overall percentage of concentration in commercial and multifamily real estate and construction and land development loans until such time real estate markets stabilize and the economy shows signs of recovery.

Construction and land development lending generally involves a higher degree of risk than permanent financing for a finished residence or commercial building, because of the inherent difficulty in estimating the cost of the project, the property's value at completion, and the future market demand for the product upon completion. If the estimated cost of construction proves to be inaccurate, the Bank may be required to advance funds beyond the amount originally committed to complete the project. To address this risk, and because of the level of construction loans in the Bank's portfolio, the Bank has personnel dedicated specifically to monitoring the progress of its construction projects, and making on-site inspections of the properties. The Bank also utilizes the services of experienced inspectors to monitor the progress and draw process in the more complex construction projects. In addition, in an effort to monitor the available inventory in its markets, the Bank also regularly reviews the overall building and development activity in its markets. In an effort to reduce the risks related to construction lending, the Bank primarily deals with experienced builders, with acceptable credit histories, sound financial statements, and a proven track record in the industry. In some instances, borrower arrangements include available lines of credit that can only be used to meet the ongoing maintenance requirements known as "interest reserves." We have 12 commercial borrowers with commitments of $34.0 million with $1.0 million in available interest reserves. There are 72 one-to-four family construction loans with commitments of $115.0 million with $3.4 million in available interest reserves. The interest reserves serve to meet the loan payment terms during the construction and completion phase of a commercial or one-to-four family real estate loans.

The risks associated with the loan portfolio are managed by the credit administration team, with established policies and procedures and oversight by senior management. The Bank has an experienced appraisal staff, and members of senior

management with related appraisal education and experience, who regularly review the appraisals utilized by the Bank in analyzing prospective construction projects. Members of the Bank's senior management and loan committees have a significant amount of experience in the areas of construction lending, appraisals, and loan underwriting, further mitigating he Bank's risk in this area. Despite all of the Bank's best efforts to address the risks involved in construction and land development lending, deteriorating economic conditions, including tightening credit markets, declining home values and higher unemployment have had a materially adverse impact on the Bank's borrowers and in particular on this segment of the Bank's loan portfolio. See the "Asset Quality" section below for details on the Bank's non-performing assets and comments regarding identified potential weaknesses in its loan portfolio.

The Bank originates construction loans through its Mortgage Loan Division and its Commercial Loan Division. The Bank's Mortgage Loan Division generally oversees the single family custom construction loans, and to a lesser extent, speculative construction loans (i.e., loans for homes that do not have a contract with a buyer for the purchase of the home upon completion of the construction) to smaller contractors building a limited number of speculative homes per year. These construction loans are further broken down in the first two lines of the table below (speculative construction one-to-four family and custom construction one-to-four family). The Bank's Commercial Lending Division is responsible for the speculative construction projects for the Bank's larger builders (including large one-to-four family developments), in addition to the Bank's multi-family construction loans, non-residential commercial construction loans, and the Bank's land development loans.

The following table is provided to show additional details on the Corporation's construction and land development loan portfolio:

                                     December 31, 2008      March 31, 2008
                                     ------------------    -----------------
(Dollars in thousands)               Amount     Percent    Amount    Percent
                                     ------     -------    ------    -------

Speculative construction one-to-
 four family                        $ 26,957      5.4%    $ 27,206     5.2%
Custom construction one-to-four
 family                                8,543      1.7%       8,097     1.6%
                                    --------    -----     --------   -----
  Total one-to-four family
   construction                       35,500      7.1%      35,303     6.8%

Commercial speculative construction
 one-to-four family                  171,648     34.3%     236,536    45.3%
Commercial construction multi family  11,619      2.3%      11,732     2.3%
Commercial construction               79,846     16.0%      54,439    10.4%
Commercial residential land
 development                         201,683     40.3%     183,828    35.2%
                                    --------    -----     --------   -----
  Total commercial construction and
   land development                  464,796     92.9%     486,535    93.2%

                                    --------    -----     --------   -----
  Total construction loans          $500,296    100.0%    $521,838   100.0%
                                    ========    =====     ========   =====

The tables below set forth the characteristics of the available for sale ("AFS") and held-to-maturity ("HTM") investment and mortgage-backed securities portfolios as of December 31, 2008:

                                               Gross       Gross
                                            Unrealized   Unrealized
                                   Gross       Losses      Losses    Estimated
                      Amortized  Unrealized  12 Months  Greater Than   Fair
(In thousands)           Cost      Gains      or Less     12 Months    Value
                      ---------  ----------  ---------  ------------ ---------


AFS Securities
 State and political
  subdivisions and U.S.
  government agency
  securities            $26,495    $1,090      $   -       $ (334)    $27,251
 Marketable equity
  securities                562       628        (16)           -       1,174
 Mortage-backed
  securities and
  collateralized
  mortgage obligations
  (CMOs)                 39,568       986          -         (600)     39,954
                        -------    ------      -----       ------     -------
  Total available-for-
   sale securities       66,625     2,704        (16)        (934)     68,379
                        -------    ------      -----       ------     -------
HTM Securities
 Mortgage-backed
  securities and
  CMOs                        9         3          -            -          12
                        -------    ------      -----       ------     -------
  Total held-to-maturity
   securities                 9         3          -            -          12
                        -------    ------      -----       ------     -------
 Total securities       $66,634    $2,707      $ (16)      $ (934)    $68,391
                        =======    ======      =====       ======     =======

. . .