General

Sound Financial, Inc. ("Sound Financial") is a federally chartered stock holding company and is subject to regulation by the Board of Governors of the Federal Reserve System ("Federal Reserve"). Sound Financial was incorporated on January 8, 2008, as part of Sound Community Bank's reorganization into the mutual holding company form of organization. As part of the reorganization, Sound Community Bank (i) converted to a stock savings bank as the successor to Sound Community Bank in its mutual form (which was originally chartered as a credit union in 1953); (ii) organized Sound Financial, which owns 100% of the common stock of Sound Community Bank; and (iii) organized Sound Community MHC, which acquired 55.0% of the common stock of Sound Financial in the reorganization. Sound MHC has no other activities or operations other than its ownership of Sound Financial. Sound Financial has no significant assets other than all of the outstanding shares of common stock of Sound Community Bank, its loan to our Employee Stock Ownership Plan and certain liquid assets.

On January 27, 2012, the boards of Sound Financial, Sound Community Bank and Sound Community MHC adopted a plan to reorganize into a full stock company and undertake a "second step" offering of new shares of common stock. The reorganization and offering, which is subject to regulatory, shareholder and depositor approval, is expected to be completed during the third quarter of 2012. As part of the reorganization, Sound Community Bank will become a wholly owned subsidiary of Sound Financial Bancorp, Inc., a newly formed Maryland stock corporation incorporated in March 2012. Shares of common stock of Sound Financial, other than those held by Sound Community MHC, will be converted into shares of common stock in Sound Financial Bancorp, Inc. using an exchange ratio designed to preserve current stockholders' (other than Sound Community MHC) percentage ownership interests in Sound Financial, Inc. Shares owned by Sound Community MHC will be retired, and new shares representing that ownership will be offered and sold to Sound Community Bank's eligible depositors, Sound Community Bank's tax-qualified employee benefit plans and members of the general public as set forth in the Plan of Conversion and Reorganization of Sound Community MHC. The Plan of Conversion and Reorganization of Sound Community MHC was filed on January 30, 2012 with the SEC in a Current Report on Form 8-K.

Substantially all of Sound Financial's business is conducted through Sound Community Bank, which is a federal savings bank subject to extensive regulation by the Office of the Comptroller of the Currency ("OCC"). Sound Community Bank's deposits are insured up to applicable limits by the Federal Deposit Insurance Corporation ("FDIC"). At March 31, 2012, Sound Financial had total consolidated assets of $348.7 million, net loans of $296.4 million, deposits of $307.8 million and stockholders' equity of $29.5 million. Shares of Sound Financial's common stock are traded on the OTC Bulletin Board under the symbol "SNFL." Our executive offices are located at 2005 5th Avenue - Suite 200, Seattle, Washington, 98121.

Our principal business consists of attracting retail 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, consumer and commercial business loans and, to a lesser extent, construction and land loans. We offer a wide variety of secured and unsecured consumer loan products, including manufactured home loans, automobile loans, boat loans and recreational vehicle loans. As part of our business, we focus on residential mortgage loan originations, many of which we sell to Fannie Mae. We sell these loans with servicing retained to maintain the direct customer relationship and promote our emphasis on strong customer service.

Our operating revenues are derived principally from earnings on interest earning assets, service charges and fees, and gains on the sale of loans and other assets. Our primary sources of funds are deposits, Federal Home Loan Bank ("FHLB") advances and other borrowings, and payments received on loans and securities. We offer a variety of deposit accounts that provide a wide range of interest rates and terms, generally including savings, money market, term certificate and demand accounts.

Our noninterest expenses consist primarily of salaries and employee benefits, expenses for occupancy, marketing and computer services and FDIC deposit insurance premiums. Salaries and benefits consist primarily of the salaries and wages paid to our employees, payroll taxes, expenses for retirement and other employee benefits. Occupancy expenses, which are the fixed and variable costs of buildings and equipment, consist primarily of lease payments, property taxes, depreciation charges, maintenance and costs of utilities

Forward-Looking Statements

When used in this Form 10-Q the words or phrases "will likely result," "are expected to," "will continue," "is anticipated," "estimate," "project," "intends" or similar expressions are intended to identify "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include statements with respect to our beliefs, plans, objectives, goals, expectations, assumptions and statements about future performance. These forward-looking statements are subject to known and unknown risks, uncertainties and other factors that could cause actual results to differ materially from the results anticipated, including, among other things,

· 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;

· legislative or regulatory changes that adversely affect our business including changes in regulatory policies and principles, or the interpretation of regulatory capital or other rules;

· monetary and fiscal policies of the Federal Reserve and the U.S. Government and other governmental initiatives affecting the financial services industry;

· results of examinations of Sound Financial 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;

· computer systems on which we depend could fail or experience a security breach;

· 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 Securities and Exchange Commission ("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.

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.

References in this document to "we," "us," and "our" means Sound Financial, Inc. and its wholly-owned subsidiary, Sound Community Bank, unless the context otherwise requires.

Critical Accounting Policies

We consider accounting policies involving significant judgments and assumptions by management that have, or could have, a material impact on the carrying value of certain assets or on income to be critical accounting policies. We consider our critical accounting policies to be those related to our allowance for loan losses, mortgage serving rights, other real estate owned, and deferred tax asset accounts. The allowance for loan losses is maintained to cover losses that are probable and can be estimated on the date of the evaluation in accordance with U.S. generally accepted accounting principles. It is management's best estimate of probable incurred credit losses in our loan portfolio. Our methodologies for analyzing the allowance for loan losses, mortgage servicing rights, other real estate owned and deferred tax asset accounts are described in our Form 10-K Annual Report for the year ended December 31, 2011.

Comparison of Financial Condition at March 31, 2012 and December 31, 2011

General. Total assets increased by $9.0 million, or 2.6%, to $348.7 million at March 31, 2012 from $339.7 million at December 31, 2011. This increase was primarily the result of a $8.4 million, or 49.2% increase in cash and cash equivalents, a $944,000, or 23.8% increase in other assets and a $752,000, or 0.3% increase in our net loan portfolio offset partially by a $756,000, or 26.8% decrease in OREO and other repossessed assets and a $668,000, or 37.0% decrease in loans held for sale. Our total liabilities increased by $8.2 million or 2.6% to $319.2 million at March 31, 2012 from $311.0 million at December 31, 2011. This increase was primarily the result of a $7.8 million, or 2.6% increase in deposits, a $299,000, or 13.9% increase in other liabilities and a $288,000, or 99.0% increase in advance payments from borrowers.

Cash and Securities. Cash, cash equivalents and our available-for-sale securities increased $8.4 million, or 42.1%, to $28.4 million at March 31, 2012. Cash and cash equivalents increased by $8.4 million, or 49.2%, to $25.4 million at March 31, 2012, as increased deposits exceeded pay-downs on borrowed funds and net loan production. Available-for-sale securities, which consist primarily of non-agency mortgage-backed securities, remained relatively unchanged, increasing by $43,000, or 1.4%, to $3.0 million at March 31, 2012. This increase reflects improved market valuations on our portfolio which were offset by investment pay-downs and impairment charges on our non-agency mortgage-backed security portfolio.

At March 31, 2012, our available-for-sale securities portfolio consisted primarily of $3.0 million of non-agency mortgage-backed securities. These securities present a higher credit risk than U.S. agency mortgage-backed securities, of which we had $58,000 at March 31, 2012. In order to monitor the increased risk, management receives and reviews a credit surveillance report from a third party quarterly, which evaluates these securities based on a number of factors, including credit scores, loan-to-value ratios, geographic locations, delinquencies and loss histories of the underlying mortgage loans. This analysis is prepared in order to project future losses based on various home price depreciation scenarios over a three-year horizon. Based on these reports, management ascertains the appropriate value for these securities and, in the first quarter of 2012, recorded an impairment charge of $91,000 on four of these non-agency securities. The current market environment significantly limits our ability to mitigate our exposure to value changes in these more risky securities by selling them, and we do not anticipate these conditions to change significantly in 2012. Accordingly, if the market and economic environment impacting the loans supporting these securities continues to deteriorate, we could determine that additional impairment must be recorded on these securities, as well as on any other securities in our portfolio. As a result, our future earnings, equity, regulatory capital and ongoing operations could be materially adversely affected.

Loans. Our total loan portfolio, including loans held for sale, remained relatively unchanged, decreasing $21,000, or 0.01%, to $301.9 million at March 31, 2012. Loans held for sale decreased from $1.8 million at December 31, 2011, to $1.1 million at March 31, 2012, reflecting the timing of origination and sales transactions late in first quarter of 2012, as compared to late 2011.

The most significant changes in our loan portfolio during the quarter included an increase of $2.3 million or 2.4% in our one-to four-family loans, and a $1.0 million or 2.5% decrease in home equity loans and lines of credit consistent with our emphasis on refinancing home equity loan balances into first position one-to four-family loans. In addition, manufactured home loans decreased by $450,000 or 2.4% while other consumer loans decreased $653,000 or 6.0% between December 31, 2011 and March 31, 2012 primarily as a result of charge-offs and lower demand from creditworthy borrowers in the current economic environment.

The following table reflects the changes in the types of loans in our loan portfolio at March 31, 2012 as compared to the end of 2011:

                                           March 31,      December
                                              2012        31, 2011       Amount Change       Percent Change
                                                                (Dollars in thousands)
One-to-four family loans                   $   98,600     $  96,305     $         2,295                  2.4 %
Home equity                                    38,654        39,656              (1,002 )               (2.5 )
Commercial and multifamily                    105,313       106,016                (703 )               (0.7 )
Construction and land                          18,226        17,805                 421                  2.4
Manufactured homes                             17,994        18,444                (450 )               (2.4 )
Other consumer                                 10,276        10,920                (644 )               (5.9 )
Commercial business                            13,291        13,163                 128                  1.0
Total                                      $  302,345     $ 302,309     $           (36 )               (0.0 )%

Mortgage Servicing Rights. At March 31, 2012, we had $2.8 million in mortgage servicing rights recorded at fair value compared to $2.4 million at December 31, 2011. The increase during the period was the result of a higher market valuation on the portfolio and an increase in our originated servicing portfolio as of March 31, 2012 compared to December 31, 2011.

Nonperforming Assets. At March 31, 2012, our nonperforming assets totaled $9.8 million, or 2.81% of total assets, compared to $9.5 million, or 2.78% of total assets at December 31, 2011.

Nonperforming loans to total loans increased to 2.57% of total loans at March 31, 2012 from 2.20% at December 31, 2011. This increase reflects a $1.1 million increase in nonperforming loans primarily due to the addition of several one- to four- family loans that became nonperforming in the first quarter of 2012 and the continuing weak economy in our market area.

Our largest nonperforming loans at March 31, 2012 consisted of a $1.2 million commercial real estate loan, a $988,000 one-to four-family loan and a $686,000 one-to four-family loan. We do not expect any material losses on these nonperforming assets in 2012 that have not been previously identified based on current appraisals and valuation estimates.

OREO and repossessed assets decreased during the first quarter of 2012 primarily due to the sale of an $873,000 commercial property as well as a $210,000 write down on an OREO property still in our possession as of March 31, 2012. During the quarter, we repossessed four personal residences and three manufactured homes. We sold two personal residences, one commercial property and three manufactured homes at an aggregate loss of $10,000. Our largest OREO at March 31, 2012, consisted of a mobile home park with a recorded value of $1.0 million in Spanaway, Washington. Our next two largest OREO properties were comprised of a $309,000 commercial property in Sequim, Washington and a $249,000 personal residence in Dayton, Washington. We do not expect to experience a material loss on any of the OREO and repossessed assets in our possession at March 31, 2012 based on current appraisals and valuation estimates.

The table below sets forth the amounts and categories of nonperforming assets in our loan portfolio at the dates indicated

                                                            Nonperforming Assets
                                            March 31,       December        Amount       Percent
                                               2012         31, 2011        Change       Change
                                                           (Dollars in thousands)
Nonperforming loans(1):
One-to four- family                        $     4,159     $     4,401     $    (242 )        (5.5 )%
Home equity                                      1,135             873           262          30.0
Commercial and multifamily                       1,806           1,219           587          48.2
Construction and land                                -              80           (80 )      (100.0 )
Other consumer                                     105              64            41          64.1
Commercial business                                524               -           524            NM
Total                                      $     7,729     $     6,637     $   1,092          16.5 %

OREO and repossessed assets:
One-to four- family                        $       592     $       478     $     114          23.8 %
Commercial and multifamily                       1,348           2,225          (877 )       (39.4 )%
Manufactured homes                                 125             118             7           5.9 %
Total                                      $     2,065     $     2,821     $    (756 )        26.7 %

Total nonperforming assets                 $     9,794     $     9,458     $     336           3.5 %
Nonperforming assets as a percentage of
total assets                                      2.80 %          2.78 %

Performing restructured loans:
One-to four- family                        $     3,563     $     2,508     $   1,055          42.1 %
Home equity                                        620             812          (192 )       (23.6 )
Commercial and multifamily                         178             785          (606 )       (77.2 )
Construction and land                               78               -            78            NM
Manufactured homes                                 734               -           734            NM
Other consumer                                      51               4            47        1175.0
Commercial business                                405              26           379        1457.7
Total                                      $     5,630     $     4,135     $   1,495          36.2 %

(1) Nonperforming loans include $3.5 million and $2.8 million in nonperforming TDRs as of March 31, 2012 and December 31, 2011.

In addition to the non-performing assets set forth in the table above, as of March 31, 2012, there were $3.0 million in loans with respect to which known information about possible credit problems of the borrowers have caused management to have doubts as to the abilities of the borrowers to comply with present loan repayment terms. This may result in the future inclusion of such loans in the nonperforming asset categories.

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 the 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.

Our allowance for loan losses at March 31, 2012 was $4.3 million, or 1.45% of total loans receivable, compared to $4.5 million, or 1.47% of total loans receivable at December 31, 2011. The $105,000, or 2.4% decrease in the allowance for loan losses reflects the $1.5 million provision for loan losses established during the first quarter of 2012 as a result of the increase in nonperforming loans and charge-offs of $1.6 million during the quarter.

Specific loan loss reserves increased $216,000, while general loan loss reserves decreased by $321,000 at March 31, 2012 compared to December 31, 2011. Net charge-offs for the three months ending March 31, 2012 were $1.6 million, or 2.14% of average loans on an annualized basis, compared to $802,000, or 1.06% of average loans for 2011. The increase in net charge-offs was primarily due to the weak economic conditions in our market area. As of March 31, 2012, the allowance for loan losses as a percentage of loans receivable and nonperforming loans was 1.45% and 56.28%, respectively, compared to 1.47% and 67.12%, respectively, at December 31, 2011. Allowance for loan losses as a percentage of loans receivable decreased slightly due to the increase in charge-offs during the period. The allowance for loan losses as a percentage of nonperforming loans decreased due to the increase in nonperforming loans.

The following table shows the adjustments in our allowance during the first three months of 2012 as compared to the same period in 2011:

                                                                  At and for the Period Ended
                                                                           March 31,
                                                                    2012                2011
                                                                    (Dollars in thousands)
Balance at beginning of period                                 $        4,455       $      4,436
Charge-offs                                                            (1,615 )             (875 )
Recoveries                                                                 10                 30
Net charge-offs                                                        (1,605 )             (845 )
Provisions charged to operations                                        1,500                825
Balance at end of period                                       $        4,350       $      4,416

Ratio of net charge-offs during the period to average loans
outstanding during the period                                            2.14 %             1.14 %

Allowance as a percentage of non-performing loans                        56.3               72.2 %

Allowance as a percentage of total loans (end of period)                 1.45 %             1.49 %

Deposits. Total deposits increased by $7.8 million, or 2.6%, to $307.8 million at March 31, 2012 from $300.0 million at December 31, 2011. During the first three months of 2012, public deposits increased $4.7 million, noninterest-bearing and interest-bearing checking accounts increased $1.4 million and $2.8 million, respectively. These increases were offset by a $1.9 million decrease in consumer certificates of deposit. Our noninterest-bearing and interest-bearing checking account increases were a result of our increased emphasis on attracting these and other low cost deposit accounts such as savings accounts. Decreases in consumer certificates of deposit were due to the low interest rate environment as maturing certificates migrated to other account types or investments.

A summary of deposit accounts with the corresponding weighted average cost of

funds is presented below

                              As of March 31, 2012              As of December 31, 2011
                                             Wtd. Avg.                           Wtd. Avg.
                            Amount             Rate             Amount              Rate
                                               (Dollars in thousands)
Checking (noninterest)   $      28,282             0.00 %   $       26,907             0.00 %
NOW (interest)                  25,141             0.08             22,332             0.09
Savings                         23,446             0.06             22,092             0.10
Money Market                    91,040             0.33             95,029             0.58
Certificates                   135,896             1.33            129,968             1.53
Escrow                           3,972             0.00              3,669             0.00
Total                    $     307,777             0.69 %   $      299,997             0.87 %

Borrowings. FHLB advances decreased $160,000, or 1.9%, to $8.3 million at March 31, 2012, with a weighted-average cost of 2.16%, from $8.5 million at December . . .