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 within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements may be identified by the use of words such as "believe," "expect," "anticipate," "intend," "should," "plan," "project," "estimate," "potential," "seek," "strive," or "try" or other conditional verbs such as "will," "would," "should," "could," or "may" or similar expressions. These forward-looking statements relate to, among other things, expectations of the business environment in which we operate, projections of future performance, perceived opportunities in the market, potential future credit experience, and statements regarding our strategies. Our ability to predict results or the actual effects of our plans or strategies is inherently uncertain. Although we believe that our plans, intentions and expectations, as reflected in these forward-looking statements are reasonable, we can give no assurance that these plans, intentions or expectations will be achieved or realized. 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: the credit risks of lending activities, including changes in the level and trend of loan delinquencies and write-offs that may be impacted by deterioration in the housing and commercial real estate markets and may lead to increased losses and non-performing assets in our loan portfolio, result in our allowance for loan losses not being adequate to cover actual losses, and require us to materially increase our reserves; changes in general economic conditions, either nationally or in our market areas; changes in the levels of general interest rates, and the relative differences between short and long term interest rates, deposit interest rates, our net interest margin and funding sources; deposit flows; fluctuations in the demand for loans, the number of unsold homes and other properties and fluctuations in real estate values in our market areas; adverse changes in the securities markets including changes in the ability of the issuers of trust preferred securities we own to repay their obligations; results of examinations of us by the Federal Reserve Bank of San Francisco and our bank subsidiary by the Federal Deposit Insurance Corporation ("FDIC"), the Washington State Department of Financial Institutions, Division of Banks ("DFI") or other regulatory authorities, including the possibility that any such regulatory authority may, among other things, require us to increase our reserve for loan losses, write-down assets, change our regulatory capital position or affect our ability to borrow funds or maintain or increase deposits, which could adversely affect our liquidity and earnings; the possibility that we will be unable to comply with the conditions imposed upon us by the Order to Cease and Desist issued by the DFI and the FDIC, including but not limited to our ability to increase our capital, reduce our non-performing assets and reduce our reliance on brokered certificates of deposit, which could result in the imposition of additional restrictions on our operations; 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 risk associated with the loans on our balance sheet; staffing fluctuations in response to product demand or the implementation of corporate strategies that affect our work force and potential associated charges; computer systems on which we depend could fail or experience a security breach, or the implementation of new technologies may not be successful; our ability to manage loan delinquency rates; 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 including changes in regulatory policies and principles, including the interpretation of regulatory capital or other rules; the availability of resources to address changes in laws, rules, or regulations or to respond to regulatory actions; adverse changes in the securities markets; the inability of key third-party providers to perform their obligations to us; changes in accounting policies, principles 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; the economic impact of war or any terrorist activities; other economic, competitive, governmental, regulatory, and technological factors affecting our operations; pricing, products and services; our ability to lease excess space in Company-owned buildings; and other risks detailed in this Form 10-Q and our Form 10-K for the fiscal year ended March 31, 2009. Any of the forward-looking statements that we make in this Form 10-Q and in the other public statements we make may turn out to be wrong because of the inaccurate assumptions we might make, because of the factors illustrated above or because of other factors that we cannot foresee. Additionally, the timing and occurrence or non-occurrence of events may be subject to circumstances beyond our control. We caution readers not to place undue reliance on any forward-looking statements. We do not undertake and specifically disclaim any obligation to revise any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances

after the date of such statements. These risks could cause our actual results for the remainder of 2009 and beyond to differ materially from those expressed in any forward-looking statements by, or on behalf of, us, and could negatively affect the Corporation's operating and stock performance.

Overview

Horizon Financial Corp. ("Horizon Financial" or the "Corporation") was formed under Washington law on May 22, 1995, and became the holding company for Horizon Bank ("Horizon Bank" or the "Bank") effective October 13, 1995. At June 30, 2009, Horizon Financial had total assets of $1.36 billion, total deposits of $1.17 billion and total equity of $47.4 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 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". Effective March 1, 2000, the Bank changed its name to its current name, "Horizon Bank". The Bank became a member of the Federal Home Loan Bank ("FHLB") of Seattle in December 1998. Effective August 1, 2005, the Bank converted from a state chartered savings bank organized under Title 32 of the Revised Code of Washington ("RCW") to a state chartered commercial bank organized under Title 30 of the RCW. The Bank's deposits are insured by the Federal Deposit Insurance Corporation ("FDIC") up to applicable limits.

The Corporation's results of operations depend on revenue generated from its net interest income and to a lesser extent from 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, mortgage origination fee income 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 real estate owned/collection expense, compensation and benefits, occupancy, equipment, data processing, marketing, automated teller machine costs, legal, accounting and, FDIC deposit insurance premiums. The Corporation's results of operations may also be affected significantly by economic and competitive conditions, changes in market interest rates, changes in real estate market conditions, governmental policies and actions of regulatory authorities, as well as other factors identified under the caption "Forward Looking Statements" above.

Financial Overview

Highlights for the first fiscal quarter ended June 30, 2009 include the following:

The net loss for the three months ended June 30, 2009 was $45.7 million or $3.81 per diluted share as compared to net income of $2.0 million or $0.17 per diluted share for the three month period ended June 30, 2008. The loss was largely due a $35.5 million provision for loan losses, a $19.4 million valuation allowance against the net deferred tax asset and an increase in non-interest expenses.
The current period losses resulted in the Bank being "significantly undercapitalized" by regulatory definition as of June 30, 2009. See Note 2 of the notes to the consolidated financial statements. A $19.4 million valuation allowance was taken against the net deferred tax asset, which is comprised of tax effected cumulative temporary differences, largely from the provision for loan losses. Management considered all evidence available, including the tax carry-back and carry-forward benefits, and concluded that it is more likely than not that the majority of the net deferred tax asset will not be available as a benefit in future periods.
During the quarter ended June 30, 2009, we charged off $204,000 associated with our measurement for other than temporary impairment of our private label mortgage-backed securities.
The provision for loan losses for the three months ended June 30, 2009 was $35.5 million as compared to the year ago quarter of $3.0 million, which was necessary to meet management's estimate for probable losses. The total non-interest expense for the three months ended June 30, 2009 was $12.3 million as compared to $7.6 million for the three months ended June 30, 2008. The largest contributors to the increase in non-interest expense came from write-downs from other real estate owned, an increase in FDIC premiums and higher costs associated with loan workouts and credit administration.

Total non-performing assets increased to $138.4 million as of June 30, 2009 compared to $104.7 million at March 31, 2009 and $38.6 million as of June 30, 2008 due in large part to a transition of delinquent loans to non-accrual status.
Total assets were $1.36 billion as of June 30, 2009 as compared to $1.47 billion as of March 31, 2009 and $1.45 billion as of June 30, 2008.
Gross loans were $1.09 billion as of June 30, 2009 as compared to $1.16 billion as of March 31, 2009 and $1.26 billion as of June 30, 2008. The decline in loans is the result of management's efforts to de-leverage the balance sheet by transitioning problem loans off the balance sheet or to real estate owned in order to market the acquired property for sale.
Total deposits were $1.2 billion as of June 30, 2009 as compared to $1.2 billion as of March 31, 2009 and $1.1 billion as of June 30, 2008. Management has increased core deposits by paying above average deposit rates and focusing the retail branches on deposit gathering campaigns. The Bank will now be limited in its ability to pay rates on deposits, which is capped at 75 basis points above the prevailing market rate as a result of its "significantly undercapitalized" status as of June 30, 2009.
The net interest margin for the three months ended June 30, 2009 was 1.73% as compared to the same period ended June 30, 2008 at 3.40%. The net interest margin has declined as a result of the increase in non-performing assets, and an increase of liquidity that is earning lower yields than the cost of the liabilities.
The Bank's regulatory Tier 1 capital ratio was 3.97% for the quarter ended June 30, 2009 compared to 7.29% as of March 31, 2009 and 9.31% as of June 30, 2008. Our regulatory capital ratios have trended downward due to the net losses resulting from provision for loan losses, the valuation allowance for the net deferred tax asset, the increase in non-interest expenses and lower net interest income.

Business 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 has 18 full-service offices, four commercial loan centers and four real estate loan centers throughout Whatcom, Skagit, Snohomish and Pierce Counties in Washington.

The Corporation's immediate business focus is to return the Bank to a well-capitalized and profitable community bank, dedicated to a diversified base of commercial lending, home mortgage lending, consumer lending, small business lending and providing competitive deposit and cash-management services to our personal and business customers. The Corporation has sought to implement this strategy by: (i) focusing our sales efforts on commercial banking opportunities; (ii) providing competitive, personalized financial services to individuals and business customers served by our branch network;
(iii) selling our fixed rate mortgages to the secondary market; (iv) working with financially challenged borrowers to achieve an efficient resolution in order to improve asset quality; (v) prudently managing our operating expenses by reducing compensation costs and renegotiating vendor contracts; (vi) seeking opportunities to meet the capital requirements set forth in the Order;
(vii) increase liquidity by offering above average deposit rates in our retail branches; though we are limited by regulation to offering deposit rates at or below the limitation of 75 basis points above the prevailing market rate as a result of the Bank's status as a "significantly undercapitalized" institution as of June 30, 2009; and (viii) reducing reliance on FHLB borrowings and brokered CDs, as we are currently prohibited from accepting or renewing brokered deposits.

One of our high priorities from the above business focus list is to increase the regulatory capital levels to the required level and to improve asset quality and deleverage the balance sheet. We mobilized our efforts beginning with the quarter ended September 30, 2008 when we expanded our special assets team, which is responsible for working out problem assets that have grown substantially over the past nine months ended June 30, 2009. We have successfully shifted some of our lending personnel within the Bank to assist with loan workouts, collections and monitoring. Our capital raise strategy includes the engagement of professional investment bankers to assist with the process of identifying and securing a capital injection.

The primary long-term business strategy of the Bank is to acquire funds in the form of deposits gathered from our retail branches and to use the funds to originate 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 and brokered deposits from its current levels as it focuses on deleveraging its balance sheet. In the future, once it has returned to adequately capitalized status or better and is no longer subject to regulatory restrictions on its asset growth, the Bank expects to increase loans at a pace that is consistent with its ability to grow core deposits in its retail and commercial branch network.

Comparison of Financial Condition at June 30, 2009 and March 31, 2009

Overview. Our assets are comprised primarily of loans for which we receive interest and principal repayments from our customers, as well as cash and investment securities. Total consolidated assets for the Corporation at June 30, 2009, decreased to $1.36 billion or 7.3% from $1.47 billion at March 31, 2009. This decrease in assets was primarily attributable to a decrease in net loans receivable to $1.03 billion as of June 30, 2009 compared to $1.12 billion as of March 31, 2009.

Loans. Total loans receivable decreased $76.4 million or 6.6% during the first quarter of fiscal 2010 to $1.09 billion at June 30, 2009 compared to $1.16 billion at March 31, 2009. The decrease in total loans receivable was attributable to reductions in several loan categories, including a $38.6 million decrease in commercial construction loans, $15.4 million in commercial land development loans, $12.1 million in one-to-four family mortgage loans and $8.7 million in commercial business loans. The commercial construction category includes commercial speculative one-to-four family (large one-to-four family developments and condominium projects), multifamily and commercial. These reductions were the result of a combination of factors, including management's efforts to work out of specific loans resulting in payoffs, $17.6 million in loan balances were transferred to the Bank's real estate owned and borrower's paid down principal balances.

As reflected in the table below, approximately 63.4% of our total net loan portfolio consists of commercial and multifamily real estate and construction and land development loans.

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

                                June 30,        %       March 31,       %
(Dollars in thousands)            2009    of Portfolio    2009    of Portfolio
                                -------   ------------  --------  ------------
One-to-four family mortgage
 loans
  One-to-four family         $  153,005       14.1%   $  167,048      14.4%
  One-to-four family
   construction                  21,396        1.9%       28,290       2.4%
  Less participations sold      (34,006)      (3.1)%     (42,853)     (3.7)%
                             ----------      -----    ----------     -----
  Net one-to-four family
     mortgage loans             140,395       12.9%      152,485      13.1%
Commercial land development     171,198       15.8%      186,580      16.0%
Commercial construction (1)     183,579       16.9%      222,207      19.1%
Multifamily residential          55,180        5.1%       51,970       4.5%
Commercial real estate          278,928       25.6%      281,481      24.2%
Commercial business loans       193,307       17.8%      201,973      17.4%
Home equity secured              54,387        5.0%       58,228       5.0%
Other consumer loans              9,301         .9%        7,717        .7%
                             ----------      -----    ----------     -----
    Subtotal                    945,880       87.1%    1,010,156      86.9%
                             ----------      -----    ----------     -----
Total loans receivable        1,086,275      100.0%    1,162,641     100.0%
                             ----------      -----    ----------     -----
Less:
  Allowance for loan losses     (51,499)                 (38,981)
                             ----------               ----------
  Net loans receivable       $1,034,776               $1,123,660
                             ==========               ==========

Net residential loans        $  136,680       13.2%   $  149,625      13.3%
Net commercial business loans   182,117       17.6%      193,687      17.2%
Net commercial real estate
 loans (2)                      655,616       63.4%      716,743      63.8%
Net consumer loans (3)           60,363        5.8%       63,605       5.7%
                             ----------      -----    ----------     -----
                             $1,034,776      100.0%   $1,123,660     100.0%
                             ==========      =====    ==========     =====

(1) Includes $33.6 million and $37.2 million in condominium construction projects at June 30, 2009 and March 31, 2009, respectively.
(2) Includes construction and development, multi-family and commercial real estate loans.
(3) Includes home equity and other consumer loans.

Management is focused on a strategy to reduce the level of exposure to construction and land development loans at this time during the economic slowdown and has discontinued this type of lending. The current concentration level could subject us to further losses resulting from declines in real estate values and the related effects on our borrowers. As a result of the volatile real estate market, we have recognized the risk in construction loans in our allowance for loan losses.

Management intends to continue reducing its concentration in construction and land development loans in order to improve liquidity and mitigate the risk to future losses.

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

                                          June 30, 2009      March 31,  2009
                                        -----------------   -----------------
(Dollars in thousands)                  Amount    Percent   Amount    Percent
                                        ------    -------   ------    -------
Speculative construction one-to-four
 family                               $ 13,374      3.6%   $ 19,280      4.4%
Custom construction one-to-four
 family                                  8,022      2.1%      9,010      2.1%
                                      --------    -----    --------    -----
  Total one-to-four family
   construction                         21,396      5.7%     28,290      6.5%

Commercial speculative construction
 one-to-four family                    107,362     28.6%    142,315     32.6%
Commercial construction multi family     4,306      1.1%      8,439      1.9%
Commercial construction                 71,911     19.1%     71,453     16.3%
Commercial residential land
 development                           171,198     45.5%    186,580     42.7%
                                      --------    -----    --------    -----
  Total commercial construction and
   land development                    354,777     94.3%    408,787     93.5%
                                      --------    -----    --------    -----
  Total construction loans            $376,173    100.0%   $437,077    100.0%
                                      ========    =====    ========    =====

Federal Home Loan Bank ("FHLB") Stock. The investment in the FHLB of Seattle stock totaled $7.25 million as of June 30, 2009 as compared to $10.0 million as of the same period one year ago. The investment in the FHLB stock is a restricted investment carried at par value ($100 per share), which approximates its fair value.

Management has evaluated the FHLB stock for impairment by giving consideration to the length of time the FHLB of Seattle is likely to withhold cash dividends, redeem stock, and meet commitments to make payments. We are carefully evaluating the impact of regulatory capital changes and the liquidity position on the potential for impairment. We have reviewed the most recent unaudited financial statements included in the March 31, 2009 Form 10-Q filing of the FHLB of Seattle. The Form 10-Q filing noted that the FHLB of Seattle did not meet one of the three statutory capital requirements. The three capital requirements are 1) risk-based capital, 2) capital-to-asset ratio, and 3) leverage capital ratio. The FHLB of Seattle did not meet the risk-based capital requirements as of March 31, 2009, but was in compliance with the other two statutory capital ratios. It was further noted in the Form 10-Q of the FHLB of Seattle that a recovery in the market value of the private-label mortgage-backed securities held by the FHLB of Seattle occurred in January and February 2009, which allowed the FHLB of Seattle to redeem $669,000 of Class B capital stock. On February 28, 2009, stock redemptions were once again halted when the private-label securities were downgraded by a rating agency. The FHLB of Seattle Board of Directors has taken steps to restore the risk-based capital by suspending the issuance of Class A stock, issuing only Class B stock (considered permanent capital) and suspended the redemption and repurchase of Class A and Class B stock and the payment of dividends until such time the deficiency of the risk-based capital ratio is corrected.

The FHLB of Seattle reported a $16.3 million loss for the quarter ended March 31, 2009. The FHLB of Seattle attributes its first quarter 2009 net loss primarily to $71.7 million of OTTI charges on certain of its private-label mortgage-backed securities that are classified as held-to-maturity. As a result of its net loss for the first quarter 2009, the FHLB of Seattle also reported a $1.1 billion accumulated other comprehensive loss and total capital of $961 million as of March 31, 2009, as compared with total capital of $1.8 billion as of December 31, 2008. The OTTI recognized in accumulated other comprehensive loss is accreted to the carrying value of each security on a prospective basis, based on the amount and timing of future cash flows, over the remaining life of each security. The accretion increases the carrying value of each security and does not affect earnings unless the security is subsequently sold or has an additional OTTI charge that is recognized in earnings. The FHLB of Seattle's first quarter 2009 OTTI charge reflects the effects of isolating the portion of the loss that is directly associated with the other than temporary impairment of the private-label mortgage-backed securities. As a result of our review and intent to hold the security to maturity, the Corporation has not recorded an OTTI charge on its investment in FHLB of Seattle stock.

Investment Securities. The Bank's investment portfolio is comprised of the following securities: government agencies, municipal bonds, mortgage-backed securities, collateralized mortgage obligations ("CMOs") and common stock. The total carrying amount of these securities was $63.4 million as of June 30, 2009 as compared to $66.9 million as of March 31, 2009, which represented a decrease of $3.5 million or 5.2%. During the quarter ended June 30, 2009, the Bank elected not to renew maturing securities or replace pay downs of principal with new investment securities.

The table below presents the available for sale ("AFS") and held-to-maturity ("HTM") amortized cost, fair value and unrealized gain or loss as of June 30, 2009:

                                               Gross       Gross
                                            Unrealized   Unrealized
                                   Gross       Losses      Losses    Estimated
. . .