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 are based on the Corporation's expectations and are subject to risks and uncertainties that cannot be predicted or quantified and are beyond the Corporation's control, including the potential that (1) the Corporation may not be able to continue as a going concern and
(2) because of our critically undercapitalized status, our regulators may initiate additional enforcement actions against us, which could include placing the Bank under conservatorship or into receivership

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 risk that the Bank will be placed into conservatorship or receivership as result of being critically undercapitalized under the PCA or because the Corporation is not able to improve its capital position; the possibility that the Bank will not be unable to comply with the conditions imposed by the Order, including but not limited to its ability to increase capital, reduce non-performing assets and reduce its reliance on brokered certificates of deposit, or to comply with statutory obligations applicable to critically undercapitalized institutions under PCA or to comply with other regulatory requirements which could result in the imposition of further enforcement action imposing additional restrictions on our operations or placing the Bank into conservatorship or receivership at any time; the credit risks of lending activities, including changes in the level and trend of loan delinquencies and write-offs; the risk that borrowers will not be able to complete construction projects in a timely fashion and/or within budget and that any guarantees, including completion guarantees will not be honored; the risk that continued negative publicity regarding our financial condition will have an adverse effect on our operations; 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 the Corporation by the Federal Reserve Bank of San Francisco and its 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,; 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 further 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 September 30, 2009, Horizon Financial had total assets of $1.30 billion, total deposits of $1.17 billion and total equity of $12.8 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 is currently subject to the Order and is critically undercapitalized under PCA and accordingly is operating under significant operating restrictions. Please refer to Notes 2 and 3 of the Selected Notes to the Consolidated Financial Statements for a discussion of regulatory actions, regulatory capital and going concern considerations.

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

Important financial results for the second fiscal quarter ended September 30, 2009 include the following:

* The net loss for the three months ended September 30, 2009 was $35.1 million or $2.93 per diluted share as compared to a net loss of $4.6 million or $0.39 per diluted share for the three month period ended September 30, 2008. The loss was largely due to a $29.0 million provision for loan losses, a $12.5 million valuation allowance against the net deferred tax asset, a decrease in interest income from non-performing assets and an increase in non-interest expenses.
* The current period losses resulted in the Bank being classified for regulatory purposes as "critically undercapitalized" by regulatory definition as of September 30, 2009 which may result in the imposition of additional enforcement actions against us by our bank regulators, and possibly the appointment of a receiver or conservator for the Bank. See Notes 2 and 3 of the Selected Notes to the Consolidated Financial Statements.
* The provision for loan losses for the three months ended September 30, 2009 was $29.0 million as compared to the year ago quarter of $12.0 million, which was necessary to meet management's estimate for probable losses.
* Charge-offs were $44.6 million for the three months ended September 30, 2009 compared to $5.6 million for the same period a year ago.

* A $12.5 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.
* The total non-interest expense for the three months ended September 30, 2009 was $10.4 million as compared to $7.8 million for the three months ended September 30, 2008. The largest contributors to the increase in non-interest expense came, an increase in FDIC premiums and higher costs associated with loan workouts and credit administration.
* Total non-performing assets increased to $128.4 million as of September 30, 2009 compared to $104.7 million at March 31, 2009 and $80.2 million as of September 30, 2008 due in large part to a transition of delinquent loans to non-accrual status.
* Total assets were $1.30 billion as of September 30, 2009 as compared to $1.47 billion as of March 31, 2009 and $1.45 billion as of September 30, 2008.
* Gross loans were $974.0 million as of September 30, 2009 as compared to $1.16 billion as of March 31, 2009 and $1.26 billion as of September 30, 2008. The decline in loans is the result of management's efforts to de-leverage the balance sheet by working out specific loans resulting in payoffs or to real estate owned in order to market the acquired property for sale.
* Total deposits were $1.17 billion as of September 30, 2009 and March 31, 2009 and $1.15 billion as of September 30, 2008. The Bank is 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 "critically undercapitalized" status as of September 30, 2009.
* The net interest margin for the three months ended September 30, 2009 was 1.64% as compared to 3.26% for the same period in 2008. 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 leverage ratio was 0.77% for the quarter ended September 30, 2009 compared to 6.11% as of March 31, 2009 and 8.38% as of September 30, 2008. Our regulatory capital ratios have declined significantly as a result of 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 increase its and the Bank's regulatory capital levels to the required level and to improve asset quality and deleverage the balance sheet. Our capital raise strategy includes the engagement of investment bankers to assist with the process of identifying and securing a capital injection. At this point in time, however, the Corporation believes that it is highly unlikely that it will be able to obtain additional outside capital that does not include the provision of substantial assistance by the FDIC or other Federal governmental authorities. The Corporation continues to consult with the FRB, FDIC and DFI on a regular basis concerning the Corporation's proposals to obtain outside capital and to develop action plans that will be acceptable to bank regulatory authorities, but there can be no assurance that these actions will be successful, or that even if one or more of the Corporation's proposals are acceptable, that these proposals will be successfully implemented.

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 also intends to deleverage its balance sheet and reduce its future reliance on FHLB advances and brokered deposits from current levels. In the future, if the Bank has returned to adequately capitalized status or better and is no longer subject to regulatory restrictions on its asset growth, the Bank expects to pursue a more moderate growth strategy, increasing loans at a pace that is consistent with its ability to grow core deposits in its retail and commercial branch network as well as prudent risk management strategies and capital levels.

Comparison of Financial Condition at September 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 September 30, 2009, decreased to $1.30 billion or 11.4% from $1.47 billion at March 31, 2009. This decrease in assets was primarily attributable to a decrease in net loans receivable to $938.1 million as of September 30, 2009 compared to $1.12 billion as of March 31, 2009.

Loans. Total loans receivable decreased $188.6 million or 16.2% to $974.0 million at September 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 $86.0 million decrease in commercial construction loans, $49.5 million in commercial land development loans, $22.4 million in one-to-four family mortgage loans and $25.6 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, $44.3 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 62.2% of our total net loan portfolio at September 30, 2009 consisted 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:

                            September 30,       %       March 31,       %
(Dollars in thousands)           2009     of Portfolio    2009    of Portfolio
                               -------    ------------  --------  ------------
One-to-four family mortgage
 loans
  One-to-four family          $144,603        14.9%   $  167,048      14.4%
  One-to-four family
   construction                 18,169         1.9%       28,290       2.4%
  Less participations sold     (32,683)       (3.4)%     (42,853)     (3.7)%
                              --------       -----    ----------     -----
     Net one-to-four family
      mortgage loans           130,089        13.4%      152,485      13.1%
Commercial land development    137,030        14.1%      186,580      16.0%
Commercial construction (1)    136,214        14.0%      222,207      19.1%
Multifamily residential         57,190         5.9%       51,970       4.5%
Commercial real estate         278,346        28.5%      281,481      24.2%
Commercial business loans      176,368        18.1%      201,973      17.4%
Home equity secured             52,418         5.4%       58,228       5.0%
Other consumer loans             6,337          .6%        7,717        .7%
                              --------       -----    ----------     -----
     Subtotal                  843,903        86.6%    1,010,156      86.9%
                              --------       -----    ----------     -----
Total loans receivable         973,992       100.0%    1,162,641     100.0%
                              --------       -----    ----------     -----
Less:
  Allowance for loan losses    (35,941)                  (38,981)
                              --------                ----------
  Net loans receivable        $938,051                $1,123,660
                              ========                ==========

Net residential loans         $128,628        13.7%   $  149,625      13.3%
Net commercial business
 loans                         167,936        17.9%      193,687      17.2%
Net commercial real estate
 loans (2)                     583,689        62.2%      716,743      63.8%
Net consumer loans (3)          57,798         6.2%       63,605       5.7%
                              --------       -----    ----------     -----
                              $938,051       100.0%   $1,123,660     100.0%
                              ========       =====    ==========     =====

(1) Includes $26.1 million and $37.2 million in condominium construction projects at September 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 measurable 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 provides additional details on the Corporation's construction and land development loan portfolio:

                                   September 30, 2009       March 31, 2009
                                 --------------------    --------------------
 (Dollars in thousands)           Amount      Percent     Amount      Percent
                                 --------     -------    --------     -------

Speculative construction
 one-to-four family              $ 11,699       4.0%    $ 19,280       4.4%
Custom construction one-to-four
 family                             6,469       2.2%       9,010       2.1%
                                 --------     -----     --------     -----
   Total one-to-four family
    construction                   18,168       6.2%      28,290       6.5%

Commercial speculative
 construction one-to-four family   80,981      27.8%     142,315      32.6%
Commercial construction multi
 family                             2,295       0.8%       8,439       1.9%
Commercial construction            52,938      18.2%      71,453      16.3%
Commercial residential land
 development                      137,031      47.0%     186,580      42.7%
                                 --------     -----     --------     -----
   Total commercial construction
    and land development          273,245      93.8%     408,787      93.5%

                                 --------     -----     --------     -----
   Total construction loans      $291,413     100.0%    $437,077     100.0%
                                 ========     =====     ========     =====

Federal Home Loan Bank ("FHLB") Stock. The investment in the FHLB of Seattle stock totaled $7.3 million as of September 30, 2009 as compared to $8.6 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 evaluates 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 June 30, 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 June 30, 2009, but was in compliance with the other two statutory capital ratios. 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. As of July 31, 2009, the FHLB of Seattle regained compliance with all three statutory capital requirements.

The FHLB of Seattle reported a $34.3 million and $50.5 million loss for the three and six months ended June 30, 2009. The FHLB of Seattle attributes its net loss primarily to $61.8 million and $133.5 million of OTTI charges for the three and six months ended June 30, 2009 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 half 2009, the FHLB of Seattle also reported a $1.2 billion accumulated other comprehensive loss and total capital of $796 million as of June 30, 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 three and six month of 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 $62.0 million as of September 30, 2009 as compared to $66.9 million as of March 31, 2009, which represented a decrease of $4.9 million or 7.3%. In an effort to increase on-balance sheet liquidity, the Bank elected not to renew maturing securities or replace pay downs of principal with new investment securities during the six months ended September 30, 2009.

The table below presents the available for sale ("AFS") amortized cost, fair value and unrealized gain or loss as of September 30, 2009:

                                               Gross       Gross
                                             Unrealized  Unrealized
                                   Gross       Losses      Losses    Estimated
                      Amortized  Unrealized  12 Months  Greater Than   Fair
                         Cost      Gains      or Less     12 Months    Value
                      ---------  ----------  ---------  ------------ ---------
(In thousands)
AFS Securities
 State and political
. . .