Sound Financial Bancorp, Inc. - Quarter Report: 2020 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q


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

For the quarterly period ended September 30, 2020


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

For the transition period from to

COMMISSION FILE NUMBER 001-35633


Sound Financial Bancorp, Inc.
(Exact Name of Registrant as Specified in its Charter)


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

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

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

None

(Former name, former address and former fiscal year, if changed since last report)

Securities registered pursuant to Section 12(b) of the Act:


Title of each class	Trading Symbol(s)	Name of each exchange on which registered

Common Stock, $0.01 par value	SFBC	The NASDAQ Stock Market LLC

Indicate by checkmark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐

Indicate by checkmark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐

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


Large accelerated filer	☐	Accelerated filer	☒

Non-accelerated filer	☐	Smaller reporting company	☒

		Emerging growth company	☐

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

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

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

As of November 4, 2020, there were 2,595,289 shares of the registrant’s common stock outstanding.

Table of Contents

SOUND FINANCIAL BANCORP, INC.

FORM 10-Q

TABLE OF CONTENTS


			Page Number
PART I FINANCIAL INFORMATION

Item 1. Financial Statements

Condensed Consolidated Balance Sheets as of September 30, 2020 and December 31, 2019 (unaudited)			4

Condensed Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2020 and 2019 (unaudited)			6

Condensed Consolidated Statements of Comprehensive Income for the Three and Nine Months Ended September 30, 2020 and 2019 (unaudited)			7

Condensed Consolidated Statements of Stockholders’ Equity for the Three and Nine Months Ended September 30, 2020 and 2019 (unaudited)			8

Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2020 and 2019 (unaudited)			10

Notes to Condensed Consolidated Financial Statements (unaudited)			12

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations			38

Item 3. Quantitative and Qualitative Disclosures About Market Risk			52

Item 4. Controls and Procedures			52

PART II OTHER INFORMATION

Item 1. Legal Proceedings			53

Item 1A. Risk Factors			53

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			54

Item 3. Defaults Upon Senior Securities			54

Item 4. Mine Safety Disclosures			54

Item 5. Other Information			54

Item 6. Exhibits			55

SIGNATURES			57

EXHIBITS

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY

Condensed Consolidated Balance Sheets (unaudited)

(In thousands, except share and per share amounts)


	September 30, 2020		December 31, 2019
ASSETS
Cash and cash equivalents	$	115,762	$	55,770
Available-for-sale securities, at fair value	13,296		9,306
Loans held-for-sale	16,063		1,063
Loans held-for-portfolio	689,434		619,887
Allowance for loan losses	(5,988)		(5,640)
Total loans held-for-portfolio, net	683,446		614,247
Accrued interest receivable	2,536		2,206
Bank-owned life insurance (“BOLI”), net	14,404		14,183
Other real estate owned (“OREO”) and repossessed assets, net	575		575
Mortgage servicing rights, at fair value	3,339		3,239
Federal Home Loan Bank (“FHLB”) stock, at cost	1,164		1,160
Premises and equipment, net	6,466		6,767
Right of use assets	6,945		7,641
Other assets	3,382		3,696
Total assets	$	867,378	$	719,853
LIABILITIES
Deposits
Interest-bearing	$	596,613	$	519,434
Noninterest-bearing demand	152,237		97,284
Total deposits	748,850		616,718
Borrowings	7,500		7,500
Accrued interest payable	213		226
Lease liabilities	7,348		8,010
Other liabilities	7,783		8,368
Advance payments from borrowers for taxes and insurance	1,678		1,305
Subordinated debt, net	11,676		—
Total liabilities	785,048		642,127
COMMITMENTS AND CONTINGENCIES (NOTE 7)
STOCKHOLDERS’ EQUITY
Preferred stock, $0.01 par value, 10,000,000 shares authorized, none issued or outstanding	—		—
Common stock, $0.01 par value, 40,000,000 shares authorized, 2,595,289 and 2,567,389 shares issued and outstanding as of September 30, 2020 and December 31, 2019, respectively	25		25
Additional paid-in capital	27,018		26,343
Unearned shares - Employee Stock Ownership Plan (“ESOP”)	(142)		(227)
Retained earnings	55,170		51,410
Accumulated other comprehensive income, net of tax	259		175
Total stockholders’ equity	82,330		77,726
Total liabilities and stockholders’ equity	$	867,378	$	719,853

Table of Contents

See notes to condensed consolidated financial statements

SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY

Condensed Consolidated Statements of Income (unaudited)

(In thousands, except share and per share amounts)


	Three Months Ended September 30,				Nine Months Ended September 30,
	2020		2019		2020		2019
INTEREST INCOME
Loans, including fees	$	8,422	$	8,195	$	25,463	$	24,514
Interest and dividends on investments, cash and cash equivalents	86		381		400		1,219
Total interest income	8,508		8,576		25,863		25,733
INTEREST EXPENSE
Deposits	1,738		1,830		5,346		4,917
Borrowings	110		100		232		674
Total interest expense	1,848		1,930		5,578		5,591
Net interest income	6,660		6,646		20,285		20,142
PROVISION (RECAPTURE) FOR LOAN LOSSES	275		250		925		(150)
Net interest income after provision (recapture) for loan losses	6,385		6,396		19,360		20,292
NONINTEREST INCOME
Service charges and fee income	510		512		1,433		1,437
Earnings on cash surrender value of bank-owned life insurance	102		81		207		267
Mortgage servicing income	260		259		739		756
Fair value adjustment on mortgage servicing rights	(623)		(90)		(1,423)		(576)
Net gain on sale of loans	1,819		305		3,399		1,000

Total noninterest income	2,068		1,067		4,355		2,884
NONINTEREST EXPENSE
Salaries and benefits	2,880		3,075		8,933		9,369
Operations	1,390		1,397		4,109		4,481
Regulatory assessments	111		(49)		480		178
Occupancy	442		509		1,437		1,560
Data processing	707		587		1,923		1,547
Net loss on OREO and repossessed assets	—		1		—		11
Total noninterest expense	5,530		5,520		16,882		17,146
Income before provision for income taxes	2,923		1,943		6,833		6,030
Provision for income taxes	588		395		1,390		1,221
Net income	$	2,335	$	1,548	$	5,443	$	4,809

Earnings per common share:
Basic	$	0.90	$	0.61	$	2.11	$	1.90
Diluted	$	0.90	$	0.60	$	2.09	$	1.87
Weighted-average number of common shares outstanding:
Basic	2,563,018		2,526,240		2,558,475		2,521,393
Diluted	2,589,241		2,578,287		2,588,101		2,572,499

See notes to condensed consolidated financial statements

SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY

Condensed Consolidated Statements of Comprehensive Income (unaudited)

(In thousands)


	Three Months Ended September 30,				Nine Months Ended September 30,
	2020		2019		2020		2019
Net income	$	2,335	$	1,548	$	5,443	$	4,809
Available for sale securities:
Unrealized holding (losses) gains arising during the period	(4)		(3)		106		90
Income tax expense (benefit) related to unrealized gains/losses	1		1		(22)		(19)
Other comprehensive (loss) income, net of tax	(3)		(2)		84		71
Comprehensive income	$	2,332	$	1,546	$	5,527	$	4,880

See notes to condensed consolidated financial statements

SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY

Condensed Consolidated Statements of Stockholders’ Equity

For the Three and Nine Months Ended September 30, 2020 and 2019 (unaudited)

(In thousands, except share and per share amounts)


	Shares	Common Stock		Additional Paid -in Capital		Unearned ESOP Shares		Retained Earnings		Accumulated Other Comprehensive Income, net of tax		Total Stockholders’ Equity
Balance, at June 30, 2020	2,593,152	$	25	$	26,894	$	(170)	$	53,224	$	262	$	80,235
Net income								2,335				2,335
Other comprehensive loss, net of tax										(3)		(3)
Share-based compensation				52								52

Cash dividends paid on common stock ($0.15 per share)								(389)				(389)
Common stock surrendered	(2,842)											—

Common stock options exercised	4,979			23								23
Allocation of ESOP shares				49		28		—				77
Balance, at September 30, 2020	2,595,289	$	25	$	27,018	$	(142)	$	55,170	$	259	$	82,330

Balance, at December 31, 2019	2,567,389	$	25	$	26,343	$	(227)	$	51,410	$	175	$	77,726
Net income								5,443				5,443
Other comprehensive income, net of tax										84		84
Share-based compensation				283								283
Restricted stock awards issued	13,600											—
Cash dividends paid on common stock ($0.65 per share)								(1,683)				(1,683)
Common stock surrendered	(3,423)											—
Restricted shares forfeited	(1,690)											—
Common stock options exercised	19,413			239								239
Allocation of ESOP shares				153		85		—				238
Balance, at September 30, 2020	2,595,289	$	25	$	27,018	$	(142)	$	55,170	$	259	$	82,330


	Shares	Common Stock		Additional Paid -in Capital		Unearned ESOP Shares		Retained Earnings		Accumulated Other Comprehensive Income, net of tax		Total Stockholders’ Equity
Balance, at June 30, 2019	2,563,488	$	25	$	25,926	$	(283)	$	48,710	$	187	$	74,565
Net income								1,548				1,548
Other comprehensive loss, net of tax										(2)		(2)
Share-based compensation				72								72
Cash dividends paid on common stock ($0.14 per share)								(359)				(359)
Common stock surrendered	(1,032)											—

Common stock options exercised	5,490			93								93
Allocation of ESOP shares				71		28						99
Balance, at September 30, 2019	2,567,946	$	25	$	26,162	$	(255)	$	49,899	$	185	$	76,016

Balance, at December 31, 2018	2,544,059	$	25	$	25,663	$	(340)	$	46,165	$	114	$	71,627
Net income								4,809				4,809
Other comprehensive income, net of tax										71		71
Share-based compensation				159								159
Cash dividends paid on common stock ($0.42 per share)								(1,075)				(1,075)
Common stock surrendered	(3,810)											—

Restricted stock awards issued	15,925											—
Common stock options exercised	11,772			131								131
Allocation of ESOP shares				209		85						294
Balance, at September 30, 2019	2,567,946	$	25	$	26,162	$	(255)	$	49,899	$	185	$	76,016

See notes to condensed consolidated financial statements

SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY

Condensed Consolidated Statements of Cash Flows (unaudited)

(In thousands)


	Nine Months Ended September 30,
	2020		2019
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	5,443	$	4,809
Adjustments to reconcile net income to net cash from operating activities:
Amortization of net discounts on investments	104		27
Provision (recapture) for loan losses	925		(150)
Depreciation and amortization	696		799
Compensation expense related to stock options and restricted stock	283		159
Fair value adjustment on mortgage servicing rights	1,423		576
Right of use assets amortization	696		756
Increase in cash surrender value of BOLI	(207)		(267)
Net change in advances from borrowers for taxes and insurance	373		514
Net gain on sale of loans	(3,399)		(1,000)
Proceeds from sale of loans held-for-sale	179,244		54,430
Originations of loans held-for-sale	(193,892)		(54,683)
Net loss on OREO and repossessed assets	—		11
Change in operating assets and liabilities:
Accrued interest receivable	(330)		81
Other assets	314		859
Accrued interest payable	(13)		75
Change in lease liabilities	(662)		(656)
Other liabilities	(585)		883
Net cash (used in) provided by operating activities	(9,587)		7,223
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of available-for-sale securities	(7,177)		(3,066)
Proceeds from principal payments, maturities and sales of available-for-sale securities	3,190		245
Net (increase) decrease in loans	(68,622)		6,694
Reduction in (purchase of) BOLI	(14)		(402)
Purchases of premises and equipment, net	(396)		(227)


Net cash (used in) provided by investing activities	(73,019)		3,244
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase in deposits	132,132		56,020
Proceeds from borrowings	87,991		91,225
Repayment of borrowings	(87,991)		(162,775)
Proceeds from subordinated debt, net	11,676		—
FHLB stock (purchased) redeemed	(4)		2,776
Allocation of ESOP shares	238		294
Dividends paid on common stock	(1,683)		(1,075)
Proceeds from common stock option exercises	239		131
Net cash provided by (used in) financing activities	142,598		(13,404)
Net change in cash and cash equivalents	59,992		(2,937)
Cash and cash equivalents, beginning of period	55,770		61,810
Cash and cash equivalents, end of period	$	115,762	$	58,873



SUPPLEMENTAL CASH FLOW INFORMATION:
Cash paid for income taxes	$	1,270	$	425
Interest paid on deposits and borrowings	5,591		5,516
Loans transferred from loans held-for-portfolio to OREO and repossessed assets	—		494
Leases right of use assets obtained in exchange for operating lease liabilities:
Right of use assets	—		8,136
Lease Liabilities	—		8,408

See notes to condensed consolidated financial statements

SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements (unaudited)

Note 1 – Basis of Presentation

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

These unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X as promulgated by the Securities and Exchange Commission (“SEC”). In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation of the financial position and results of operations for the periods presented have been included. Certain information and disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to the rules and regulations of the SEC. These unaudited financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2019, as filed with the SEC on March 12, 2020 (“2019 Form 10-K”). The results for the interim periods are not necessarily indicative of results for a full year.

Certain amounts in the prior period’s consolidated financial statements have been reclassified to conform to the current presentation. These classifications do not have an impact on previously reported consolidated net income, retained earnings, stockholders’ equity or earnings per share.

Note 2 – Accounting Pronouncements Recently Issued or Adopted

On March 27, 2020, President Trump signed into law the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”), which provides relief from certain accounting and financial reporting requirements under U.S. GAAP. Section 4013 of the CARES Act provides temporary relief from the accounting and reporting requirements for troubled debt restructurings (TDRs) under ASC 310-40 for loan modifications related to the novel coronavirus disease of 2019 (“COVID-19”) pandemic. In addition, on April 7, 2020, a group of banking agencies issued an interagency statement (“Interagency Statement”) for evaluating whether loan modifications that occur in response to the COVID-19 pandemic are TDRs. The Interagency Statement was originally issued on March 22, 2020, but the banking agencies revised it to address the relationship between their TDR accounting and disclosure guidance and the TDR guidance in Section 4013 of the CARES Act. Section 4013 of the CARES Act permits the suspension of ASC 310-40 for loan modifications that are made by financial institutions in response to the COVID-19 pandemic if (1) the borrower was not more than 30 days past due as of December 31, 2019, and (2) the modifications are related to arrangements that defer or delay the payment of principal or interest, or change the interest rate on the loan. The Interagency Statement indicates that a lender can conclude that a borrower is not experiencing financial difficulty if either (1) short-term (e.g., six months) modifications are made in response to COVID-19, such as payment deferrals, fee waivers, extensions of repayment terms, or other delays in payment that are insignificant related to loans in which the borrower is less than 30 days past due on its contractual payments at the time a modification program is implemented, or (2) the modification or deferral program is mandated by the federal government or a state government. Accordingly, any loan modification made in response to the COVID-19 pandemic that meets either of these practical expedients would not be considered a TDR. The Company adopted this guidance effective March 27, 2020.

In October 2020, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2020-08, “Receivables – Nonrefundable Fees and Other Costs” (“ASU 2020-08”). ASU 2020-08 clarifies that the Company should reevaluate whether a callable debt security is within the scope of paragraph 310-20-35-33 for each reporting period. ASU 2020-08 is effective for fiscal years beginning after December 15, 2020, including interim periods within those fiscal years. The Company does not expect the adoption of ASU 2020-08 to have a material impact on its consolidated financial statements.

In March 2020, the FASB issued ASU No. 2020-04, Reference Rate Reform (Topic 848). This ASU provides optional guidance for a limited period of time to ease the potential burden in accounting for (or recognizing the effects of) reference rate reform on financial reporting. The amendments in this update apply to contract modifications that replace a reference rate affected by reference rate reform (including rates referenced in fallback provisions) and contemporaneous modifications of other contract terms related to the replacement of the reference rate (including contract modifications to add or change fallback provisions). The following optional expedients for applying the requirements of certain Topics or Industry Subtopics in the Codification are permitted for contracts that are modified because of reference rate reform and that meet certain scope guidance: 1)

Modifications of contracts within the scope of Topics 310, Receivables, and 470, Debt, should be accounted for by prospectively adjusting the effective interest rate; 2) Modifications of contracts within the scope of Topics 840, Leases, and 842, Leases, should be accounted for as a continuation of the existing contracts with no reassessments of the lease classification and the discount rate (for example, the incremental borrowing rate) or remeasurements of lease payments that otherwise would be required under those Topics for modifications not accounted for as separate contracts; and 3) Modifications of contracts do not require an entity to reassess its original conclusion about whether that contract contains an embedded derivative that is clearly and closely related to the economic characteristics and risks of the host contract under Subtopic 815-15, Derivatives and Hedging— Embedded Derivatives. The amendments in this update are effective for all entities as of March 12, 2020 through December 31, 2022. The Company does not expect the adoption of ASU 2020-04 to have a material impact on its consolidated financial statements.

In December 2019, the FASB issued ASU No. 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes (ASU 2019-12). This ASU simplifies the accounting for income taxes by removing the exception to the incremental approach for intra-period tax allocation when there is a loss from continuing operations and income or a gain from other items, removing the requirement to recognize a deferred tax liability for equity method investments when a foreign subsidiary becomes an equity method investment, and removing the general methodology for calculating income taxes in an interim period when a year-to-date loss exceeds the anticipated loss for the year. This ASU is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020. The Company does not expect the adoption of ASU 2019-12 to have a material impact on its consolidated financial statements.

In August 2018, the FASB issued ASU No. 2018-14, Compensation - Retirement Benefits - Defined Benefit Plans - General (Subtopic 715-20): Disclosure Framework - Changes to the Disclosure Requirements for Defined Benefit Plans. This ASU modifies disclosure requirements for employers that sponsor defined benefit pension or other postretirement plans. Disclosure requirements removed from FASB Subtopic 715-20 include the amounts in accumulated other comprehensive income expected to be recognized as components of net periodic benefit cost over the next fiscal year, the amount and timing of plan assets expected to be returned to the employer, related party disclosures about the amount of future annual benefits covered by insurance and annuity contracts and significant transactions between the employer or related parties and the plan, and, for public entities, the effects of a one-percentage-point change in assumed health care cost trend rates on the aggregate of the service and interest cost components of net periodic benefit costs and benefit obligation for postretirement health care benefits. Disclosure requirements added to FASB Subtopic 715-20 include the weighted-average interest crediting rates for cash balance plans and other plans with promised interest crediting rates, and an explanation of the reasons for significant gains and losses related to changes in the benefit obligation for the period. This ASU is effective for fiscal years ending after December 15, 2020. The Company does not expect the adoption of ASU 2018-14 to have a material impact on its consolidated financial statements.

In August 2018, the FASB issued ASU No. 2018-13, Fair Value Measurement: Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement. This ASU modifies the disclosure requirements on fair value measurements by removing the amount of and reasons for transfers between Level 1 and Level 2 of the fair value hierarchy, the policy for timing of transfers between levels, and the valuation processes for Level 3 fair value measurements. This ASU clarifies that the measurement uncertainty disclosure is to communicate information about the uncertainty in measurement as of the reporting date. The ASU adds disclosure requirements for Level 3 measurements, including changes in unrealized gains and losses for the period included in other comprehensive income for the recurring Level 3 fair value measurements held at the end of the reporting period, and the range and weighted average of significant unobservable inputs used to develop Level 3 fair value measurements. Amendments in this ASU are effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. The adoption of ASU 2018-13 did not have a material impact on the Company's consolidated financial statements.

In June 2018, the FASB issued ASU No. 2018-07, Compensation - Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting. This ASU amends the accounting for share-based payments awards to nonemployees to align with the accounting for employee awards. Under the new guidance, the existing employee guidance will apply to nonemployee share-based transactions (as long as the transaction is not effectively a form of financing), with the exception of specific guidance related to the attribution of compensation cost. The cost of nonemployee awards will continue to be recorded as if the grantor had paid cash for the goods or services. In addition, the contractual term will be able to be used in lieu of an expected term in the option-pricing model for nonemployee awards. Amendments in this ASU are effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2018 and early adoption is permitted. The adoption of ASU No. 2018-07 on January 1, 2019 did not have a material impact on the Company's consolidated financial statements.

In August 2017, the FASB issued ASU No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities. This ASU amends the hedge accounting recognition and presentation requirements in ASC 815 to improve the transparency and understandability of information conveyed to financial statement users about an entity's risk management activities by better aligning the entity's financial reporting for hedging relationships with those risk management activities and reduce the complexity of and simplify the application of hedge accounting by preparers. The amendments in this ASU permit hedge accounting for hedging relationships involving nonfinancial risk and interest rate risk by removing certain limitations in cash flow and fair value hedging relationships. In addition, the ASU requires an entity to present the earnings effect of the hedging instrument in the same income statement line item in which the earnings effect of the hedged item is reported. The amendments in this ASU are effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2018 and early adoption is permitted. The adoption of ASU No. 2017-12 on January 1, 2019, did not have a material impact on the Company's consolidated financial statements.

In March 2017, the FASB issued ASU No. 2017-08, Receivables-Nonrefundable Fees and Other Costs (Subtopic 310-20). ASU 2017-08 is intended to amend the amortization period for certain purchased callable debt securities held at a premium. Under ASU 2017-08, the FASB is shortening the amortization period for the premium to the earliest call date. Under current GAAP, entities generally amortize the premium as an adjustment of yield over the contractual life of the instrument. ASU 2017-08 is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2018. The adoption of ASU No. 2017-08 on January 1, 2019 did not have a material impact on the Company's consolidated financial statements.

In January 2017, the FASB issued ASU No. 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment, or ASU 2017-04, which eliminates Step 2 from the goodwill impairment test. ASU 2017-04 also eliminates the requirements for any reporting unit with a zero or negative carrying amount to perform a qualitative assessment and, if it fails that qualitative test, to perform Step 2 of the goodwill impairment test. An entity still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary. Adoption of ASU 2017-04 is required for annual or interim goodwill impairment tests in fiscal years beginning after December 15, 2019 with early adoption permitted for annual or interim goodwill impairment tests performed on testing dates after January 1, 2017. The Company’s adoption of ASU 2017-04 did not have a material impact on its consolidated financial statements.

In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments- Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. This ASU replaces the existing incurred loss impairment methodology that recognizes credit losses when a probable loss has been incurred with new methodology where loss estimates are based upon lifetime expected credit losses. The amendments in this ASU require a financial asset that is measured at amortized cost to be presented at the net amount expected to be collected. The income statement would then reflect the measurement of credit losses for newly recognized financial assets as well as changes to the expected credit losses that have taken place during the reporting period. The change in allowance recognized as a result of adoption will occur through a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the ASU is adopted. The FASB issued ASU 2019-10, Financial Instruments- Credit Losses (Topic 326), delaying implementation of ASU 2016-13 for SEC smaller reporting company filers until fiscal year beginning after 2022. The Bank meets the requirements of a smaller reporting company and delayed implementation of ASU 2016-13.

In February 2016, FASB issued ASU No. 2016-02, Leases (Topic 842). ASU No. 2016-02 requires lessees to recognize, on the balance sheet, the assets and liabilities arising from operating leases. A lessee should recognize a liability to make lease payments and a right-of-use asset representing its right to use the underlying asset for the lease term. A lessee should include payments to be made in an optional period only if the lessee is reasonably certain to exercise an option to extend the lease or not to exercise an option to terminate the lease. For a finance lease, interest payments should be recognized separately from amortization of the right-of-use asset in the statement of comprehensive income. For operating leases, the lease cost should be allocated over the lease term on a generally straight-line basis. In July 2018, the FASB issued ASU No. 2018-11, Leases (Topic 842), Targeted Improvements. This ASU amended the new leases standard to give entities another option for transition and to provide lessors with a practical expedient. The transition option allows entities to not apply the new leases standard in the comparative periods they present in their financial statements in the year of adoption. The practical expedient provides lessors with an option to not separate non-lease components from the associated lease components when certain criteria are met and requires them to account for the combined component in accordance with the new revenue standard if the associated non-lease components are the predominant components. The Company adopted these ASUs on January 1, 2019. In March 2019, FASB issued ASU 2019-01, Leases (Topic 842), Codification Improvements. The amendments in this ASU include determining the fair value of the underlying asset by lessors that are not manufacturers or dealers, requiring cash received from lessors from sales-type and direct financing leases to be presented in the cash flow statement within investing activities, and clarifying interim disclosure requirements. The effective date and transition requirements for the first and second items of this ASU are effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2019 and early

adoption is permitted. We have adopted the third item of this ASU and provided the required interim disclosures in this report. See Note 12- Leases for further information.

Note 3 – Investments

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


	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Estimated Fair Value
September 30, 2020
Treasury bills	$	1,976	$	—	$	—	$	1,976
Municipal bonds	5,060		196		(2)		5,254
Agency mortgage-backed securities	5,932		135		(1)		6,066
Total	$	12,968	$	331	$	(3)	$	13,296

December 31, 2019
Municipal bonds	$	3,197	$	173	$	—	$	3,370
Agency mortgage-backed securities	5,888		56		(8)		5,936
Total	$	9,085	$	229	$	(8)	$	9,306

The amortized cost and fair value of AFS securities at September 30, 2020, by contractual maturity, are shown below (in thousands). Expected maturities of AFS securities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Investments not due at a single maturity date, primarily mortgage-backed investments, are shown separately.


	September 30, 2020
	Amortized Cost		Fair Value
Due within one year	$	3,014	$	3,016
Due after one year through five years	489		506
Due after five years through ten years	1,426		1,479
Due after ten years	2,107		2,228
Mortgage-backed securities	5,932		6,067
Total	$	12,968	$	13,296

There were no pledged securities at September 30, 2020 or December 31, 2019.

There were no sales of AFS securities during the three and nine months ended September 30, 2020 or 2019.

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


	September 30, 2020
	Less Than 12 Months				12 Months or Longer				Total
	Fair Value		Unrealized Loss		Fair Value		Unrealized Loss		Fair Value		Unrealized Loss
Treasury bills	$	1,033	$	—	$	—	$	—	$	1,033	$	—
Municipal bonds	909		(2)		—		—		909		(2)
Agency mortgage-backed securities	210		(1)		—		—		210		(1)
	$	2,152	$	(3)	$	—	$	—	$	2,152	$	(3)


	December 31, 2019
	Less Than 12 Months				12 Months or Longer				Total
	Fair Value		Unrealized Loss		Fair Value		Unrealized Loss		Fair Value		Unrealized Loss
Municipal bonds	$	3,387	$	(8)	$	—	$	—	$	3,387	$	(8)
Total	$	3,387	$	(8)	$	—	$	—	$	3,387	$	(8)

There were no credit losses recognized in earnings during the three and nine months ended September 30, 2020 or 2019 relating to the Company’s securities.

At September 30, 2020, the securities portfolio consisted of 16 agency mortgage-backed securities, ten municipal bonds and three short-term treasury bills with a total portfolio fair value of $13.3 million. At December 31, 2019, the securities portfolio consisted of 13 agency mortgage-backed securities and eight municipal bonds with a fair value of $9.3 million. At September 30, 2020, there were four securities in an unrealized loss position for less than 12 months, and there were no securities in an unrealized loss position for more than 12 months. At December 31, 2019, there were five securities in an unrealized loss position for less than 12 months, and there were no securities in an unrealized loss position for more than 12 months. The unrealized losses were caused by changes in market interest rates or the widening of market spreads subsequent to the initial purchase of these securities, and not related to the underlying credit of the issuers or the underlying collateral. It is expected that these securities will not be settled at a price less than the amortized cost of each investment. The unrealized losses on these investments are not considered other-than-temporary impairment ("OTTI") as of September 30, 2020, because the decline in fair value is not attributable to credit quality and because we do not intend, and it is not likely that we will be required, to sell these securities before recovery of their amortized cost basis. Additional deterioration in market and economic conditions related to the COVID-19 pandemic may, however, have an adverse impact on credit quality in the future and result in OTTI charges.

Note 4 – Loans

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


	September 30, 2020		December 31, 2019
Real estate loans:
One-to-four family	$	140,356	$	149,393
Home equity	17,727		23,845
Commercial and multifamily	275,876		261,268
Construction and land	72,166		75,756
Total real estate loans	506,125		510,262
Consumer loans:
Manufactured homes	20,948		20,613
Floating homes	42,399		43,799
Other consumer	12,252		8,302
Total consumer loans	75,599		72,714
Commercial business loans	111,025		38,931
Total loans held-for-portfolio	692,749		621,907
Deferred fees, net	(3,315)		(2,020)
Total loans held-for-portfolio, gross	689,434		619,887
Allowance for loan losses	(5,988)		(5,640)
Total loans held-for-portfolio, net	$	683,446	$	614,247

The Company was automatically authorized to participate in the SBA Paycheck Protection Program (“PPP”), as a qualified U.S. Small Business Administration’s (“SBA”) lender. As of September 30, 2020, the Bank had funded PPP loans totaling $74.8 million, which are included in commercial business loans above.

The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on impairment method as of September 30, 2020 (in thousands):


	Allowance: Individually evaluated for impairment		Allowance: Collectively evaluated for impairment		Allowance: Ending balance		Loans held for investment: Individually evaluated for impairment		Loans held for investment: Collectively evaluated for impairment		Loans held for investment: Ending balance

One-to-four family	$	207	$	963	$	1,170	$	6,059	$	134,297	$	140,356
Home equity	18		124		142		294		17,433		17,727
Commercial and multifamily	—		2,007		2,007		577		275,299		275,876
Construction and land	6		574		580		592		71,574		72,166
Manufactured homes	184		146		330		333		20,615		20,948
Floating homes	—		293		293		529		41,870		42,399
Other consumer	31		84		115		117		12,135		12,252
Commercial business	—		263		263		617		110,408		111,025
Unallocated	—		1,088		1,088		—		—		—
Total	$	446	$	5,542	$	5,988	$	9,118	$	683,631	$	692,749

The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on impairment method as of December 31, 2019 (in thousands):


	Allowance: Individually evaluated for impairment		Allowance: Collectively evaluated for impairment		Allowance: Ending balance		Loans held for investment: Individually evaluated for impairment		Loans held for investment: Collectively evaluated for impairment		Loans held for investment: Ending balance

One-to-four family	$	205	$	915	$	1,120	$	8,620	$	140,773	$	149,393
Home equity	25		153		178		335		23,510		23,845
Commercial and multifamily	—		1,696		1,696		353		260,915		261,268
Construction and land	7		485		492		1,215		74,541		75,756
Manufactured homes	349		131		480		440		20,173		20,613
Floating homes	—		283		283		290		43,509		43,799
Other consumer	54		58		112		143		8,159		8,302
Commercial business	84		247		331		997		37,934		38,931
Unallocated	—		948		948		—		—		—
Total	$	724	$	4,916	$	5,640	$	12,393	$	609,514	$	621,907

The following tables summarize the activity in the allowance for loan losses for the three and nine months ended September 30, 2020 (in thousands):


	Three Months Ended September 30, 2020
	Beginning Allowance		Charge-offs		Recoveries		Provision (Recapture)		Ending Allowance
One-to-four family	$	1,149	$	(20)	$	4	$	37	$	1,170
Home equity	154		(2)		7		(17)		142
Commercial and multifamily	1,991		—		—		16		2,007
Construction and land	623		—		—		(43)		580
Manufactured homes	362		—		1		(33)		330
Floating homes	324		—		—		(31)		293
Other consumer	127		(4)		2		(10)		115
Commercial business	501		(306)		—		68		263
Unallocated	800		—		—		288		1,088
Total	$	6,031	$	(332)	$	14	$	275	$	5,988


	Nine Months Ended September 30, 2020
	Beginning Allowance		Charge-offs		Recoveries		Provision (Recapture)		Ending Allowance
One-to-four family	$	1,120	$	(20)	$	12	$	58	$	1,170
Home equity	178		(2)		46		(80)		142
Commercial and multifamily	1,696		—		—		311		2,007
Construction and land	492		—		—		88		580
Manufactured homes	480		—		1		(151)		330
Floating homes	283		—		—		10		293
Other consumer	112		(20)		13		10		115
Commercial business	331		(607)		—		539		263
Unallocated	948		—		—		140		1,088
Total	$	5,640	$	(649)	$	72	$	925	$	5,988

The following tables summarize the activity in the allowance for loan losses for the three and nine months ended September 30, 2019 (in thousands):


	Three Months Ended September 30, 2019
	Beginning Allowance		Charge-offs		Recoveries		(Recapture) Provision		Ending Allowance
One-to-four family	$	1,139	$	—	$	3	$	23	$	1,165
Home equity	165		—		2		10		177
Commercial and multifamily	1,467		—		—		186		1,653
Construction and land	464		(1)		—		36		499
Manufactured homes	463		—		—		32		495
Floating homes	262		—		—		1		263
Other consumer	120		(8)		1		(3)		110
Commercial business	509		—		1		(191)		319
Unallocated	781		—		—		156		937
Total	$	5,370	$	(9)	$	7	$	250	$	5,618


	Nine Months Ended September 30, 2019
	Beginning Allowance		Charge-offs		Recoveries		Provision (Recapture)		Ending Allowance
One-to-four family	$	1,314	$	—	$	3	$	(152)	$	1,165
Home equity	202		—		8		(33)		177
Commercial and multifamily	1,638		—		—		15		1,653
Construction and land	431		—		—		68		499
Manufactured homes	427		—		—		68		495
Floating homes	265		—		—		(2)		263
Other consumer	112		(41)		23		16		110
Commercial business	356		—		1		(38)		319
Unallocated	1,029		—		—		(92)		937
Total	$	5,774	$	(41)	$	35	$	(150)	$	5,618

Credit Quality Indicators. Federal regulations provide for the classification of lower quality loans as substandard, doubtful or loss. An asset is considered substandard if it is inadequately protected by the current net worth and payment capacity of the borrower or of any collateral pledged. Substandard assets include those characterized by the distinct possibility that we will sustain some loss if the deficiencies are not corrected. Assets classified as doubtful have all the weaknesses inherent in assets classified substandard with the added characteristic that the weaknesses make collection or liquidation of the assets in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable. Assets classified as loss are those considered uncollectible and of such little value that their continuance as assets without establishment of a specific loss reserve is not warranted.

When we classify problem loans as either substandard or doubtful, we may establish a specific allowance in an amount we deem prudent to address the risk specifically (if the loan is impaired) or we may allow the loss to be addressed in the general allowance (if the loan is not impaired). General allowances represent loss reserves which have been established to recognize the inherent risk associated with lending activities, but which, unlike specific allowances, have not been specifically allocated to particular problem loans. When the Company classifies problem loans as a loss, we charge-off such assets in the period in which they are deemed uncollectible. Assets that do not currently expose us to sufficient risk to warrant classification as substandard, doubtful or loss, but possess identified weaknesses, are classified as either watch or special mention assets. Our determination as to the classification of our assets and the amount of our valuation allowances is subject to review by the Federal Deposit Insurance Corporation, the Bank’s federal regulator, and the Washington Department of Financial Institutions, the Bank’s state banking regulator, both of whom can order the establishment of additional loss allowances. Pass rated loans are loans that are not otherwise classified or criticized.

The following table presents the internally assigned grades as of September 30, 2020, by type of loan (in thousands):


	One-to- four family		Home equity		Commercial and multifamily		Construction and land		Manufactured homes		Floating homes		Other consumer		Commercial business		Total
Grade:
Pass	$	120,789	$	16,906	$	235,013	$	25,748	$	19,670	$	41,870	$	12,197	$	102,864	$	575,057
Watch	15,100		269		25,147		42,149		1,033		—		13		5,859		89,570
Special Mention	—		—		10,852		3,666		—		—		—		395		14,913
Substandard	4,467		552		4,864		603		245		529		42		1,907		13,209
Doubtful	—		—		—		—		—		—		—		—		—
Loss	—		—		—		—		—		—		—		—		—
Total	$	140,356	$	17,727	$	275,876	$	72,166	$	20,948	$	42,399	$	12,252	$	111,025	$	692,749

The following table presents the internally assigned grades as of December 31, 2019, by type of loan (in thousands):


	One-to- four family		Home equity		Commercial and multifamily		Construction and land		Manufactured homes		Floating homes		Other consumer		Commercial business		Total
Grade:
Pass	$	138,900	$	23,206	$	256,139	$	68,268	$	20,204	$	43,509	$	8,250	$	35,347	$	593,823
Watch	—		—		217		2,634		124		—		—		378		3,353
Special Mention	2,484		—		2,178		3,677		—		—		—		1,649		9,988
Substandard	8,009		639		2,734		1,177		285		290		52		1,557		14,743
Doubtful	—		—		—		—		—		—		—		—		—
Loss	—		—		—		—		—		—		—		—		—
Total	$	149,393	$	23,845	$	261,268	$	75,756	$	20,613	$	43,799	$	8,302	$	38,931	$	621,907

Nonaccrual and Past Due Loans. Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are placed on nonaccrual once the loan is 90 days past due or sooner if, in management’s opinion, the borrower may be unable to meet payment of obligations as they become due, as well as when required by regulatory provisions. Loans are not placed on nonaccrual for short-term loan modifications made in response to the COVID-19 pandemic.

The following table presents the recorded investment in nonaccrual loans as of September 30, 2020, and December 31, 2019, by type of loan (in thousands):


	September 30, 2020		December 31, 2019
One-to-four family	$	1,602	$	2,090
Home equity	146		261
Commercial and multifamily	353		353
Construction and land	555		1,177
Manufactured homes	131		226
Floating homes	529		290
Other consumer	—		—
Commercial business	—		260
Total	$	3,316	$	4,657

The following table presents the aging of the recorded investment in past due loans as of September 30, 2020, by type of loan (in thousands):


	30-59 Days Past Due		60-89 Days Past Due		90 Days and Greater Past Due		> 90 Days and Accruing		Total Past Due		Current		Total Loans
One-to-four family	$	161	$	179	$	1,602	$	—	$	1,942	$	138,414	$	140,356
Home equity	19		8		146		—		173		17,554		17,727
Commercial and multifamily	2,196		999		353		—		3,548		272,328		275,876
Construction and land	—		—		555		—		555		71,611		72,166
Manufactured homes	48		41		131		—		220		20,728		20,948
Floating homes	—		—		529		—		529		41,870		42,399
Other consumer	15		11		—		—		26		12,226		12,252
Commercial business	275		—		—		—		275		110,750		111,025
Total	$	2,714	$	1,238	$	3,316	$	—	$	7,268	$	685,481	$	692,749

The following table presents the aging of the recorded investment in past due loans as of December 31, 2019, by type of loan (in thousands):


	30-59 Days Past Due		60-89 Days Past Due		90 Days and Greater Past Due		> 90 Days and Accruing		Total Past Due		Current		Total Loans
One-to-four family	$	789	$	105	$	1,810	$	—	$	2,704	$	146,689	$	149,393
Home equity	81		161		197		—		439		23,406		23,845
Commercial and multifamily	1,742		—		353		—		2,095		259,173		261,268
Construction and land	3,340		1,100		50		—		4,490		71,266		75,756
Manufactured homes	324		43		125		—		492		20,121		20,613
Floating homes	297		250		290		—		837		42,962		43,799
Other consumer	19		2		—		—		21		8,281		8,302
Commercial business	226		—		162		—		388		38,543		38,931
Total	$	6,818	$	1,661	$	2,987	$	—	$	11,466	$	610,441	$	621,907

Nonperforming Loans. Loans are considered nonperforming when they are placed on nonaccrual.

The following table presents the credit risk profile of our loan portfolio based on payment activity as of September 30, 2020, by type of loan (in thousands):


	One-to-four family		Home equity		Commercial and multifamily		Construction and land		Manufactured homes		Floating homes		Other consumer		Commercial business		Total
Performing	$	138,754	$	17,581	$	275,523	$	71,611	$	20,817	$	41,870	$	12,252	$	111,025	$	689,433
Nonperforming	1,602		146		353		555		131		529		—		—		3,316
Total	$	140,356	$	17,727	$	275,876	$	72,166	$	20,948	$	42,399	$	12,252	$	111,025	$	692,749

The following table presents the credit risk profile of our loan portfolio based on payment activity as of December 31, 2019, by type of loan (in thousands):


	One-to-four family		Home equity		Commercial and multifamily		Construction and land		Manufactured homes		Floating homes		Other consumer		Commercial business		Total
Performing	$	147,303	$	23,584	$	260,915	$	74,579	$	20,387	$	43,509	$	8,302	$	38,671	$	617,250
Nonperforming	2,090		261		353		1,177		226		290		—		260		4,657
Total	$	149,393	$	23,845	$	261,268	$	75,756	$	20,613	$	43,799	$	8,302	$	38,931	$	621,907

Impaired Loans. A loan is considered impaired when we determine that we may be unable to collect payments of principal or interest when due under the terms of the loan. In the process of identifying loans as impaired, we take into consideration factors which include payment history and status, collateral value, financial condition of the borrower, and the probability of collecting scheduled payments in the future. Minor payment delays and insignificant payment shortfalls typically do not result in a loan being classified as impaired. The significance of payment delays and shortfalls is considered on a case by case basis, after taking into consideration the totality of circumstances surrounding the loan and the borrower, including payment history. Impairment is measured on a loan by loan basis for all loans in the portfolio. All TDRs are also classified as impaired loans and are included in the loans individually evaluated for impairment in the calculation of the allowance for loan losses.

Impaired loans at September 30, 2020 and December 31, 2019, by type of loan were as follows (in thousands):


	September 30, 2020
			Recorded Investment
	Unpaid Principal Balance		Without Allowance		With Allowance		Total Recorded Investment		Related Allowance
One-to-four family	$	6,122	$	4,517	$	1,542	$	6,059	$	207
Home equity	294		151		143		294		18
Commercial and multifamily	574		577		—		577		—
Construction and land	592		555		37		592		6
Manufactured homes	330		90		243		333		184
Floating homes	529		529		—		529		—
Other consumer	117		—		117		117		31
Commercial business	616		617		—		617		—
Total	$	9,174	$	7,036	$	2,082	$	9,118	$	446


	December 31, 2019
			Recorded Investment
	Unpaid Principal Balance		Without Allowance		With Allowance		Total Recorded Investment		Related Allowance
One-to-four family	$	8,748	$	7,236	$	1,384	$	8,620	$	205
Home equity	335		256		79		335		25
Commercial and multifamily	353		353		—		353		—
Construction and land	1,215		1,177		38		1,215		7
Manufactured homes	445		46		394		440		349
Floating homes	290		290		—		290		—
Other consumer	143		—		143		143		54
Commercial business	997		714		283		997		84
Total	$	12,526	$	10,072	$	2,321	$	12,393	$	724

The following tables present the average recorded investment and interest income recognized on impaired loans for the three and nine months ended September 30, 2020 and 2019, respectively, by loan types (in thousands):


	Three Months Ended September 30, 2020				Three Months Ended September 30, 2019
	Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
One-to-four family	$	6,027	$	69	$	4,011	$	65
Home equity	336		3		1,998		14
Commercial and multifamily	465		16		501		—
Construction and land	315		20		121		1
Manufactured homes	349		5		462		14
Floating homes	405		15		—		—
Other consumer	127		—		150		2
Commercial business	1,076		12		694		—
Total	$	9,100	$	140	$	7,937	$	96


	Nine Months Ended September 30, 2020				Nine Months Ended September 30, 2019
	Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
One-to-four family	$	6,650	$	208	$	3,831	$	125
Home equity	341		12		1,302		23
Commercial and multifamily	409		26		1,022		8
Construction and land	579		21		273		3
Manufactured homes	391		19		460		31
Floating homes	406		23		—		—
Other consumer	134		4		157		6
Commercial business	1,174		12		1,103		20
Total	$	10,084	$	325	$	8,148	$	216

Forgone interest on nonaccrual loans was $62,000 and $126,000 for the three and nine months ended September 30, 2020, respectively, compared to $74,000 and $165,000 for the three and nine months ended September 30, 2019, respectively. There were no commitments to lend additional funds to borrowers whose loans were classified as nonaccrual or impaired at September 30, 2020 and December 31, 2019.

Troubled debt restructurings. TDRs are accounted for under ASC 310-40, are loans which have renegotiated loan terms to assist borrowers who are unable to meet the original terms of their loans. Such modifications to loan terms may include a lower interest rate, a reduction in principal, or a longer term to maturity. Once a TDR has performed according to its modified terms for six months and the collection of principal and interest under the revised terms is deemed probable, we remove the TDR from nonperforming status. Loans classified as TDRs totaled $5.6 million and $7.9 million at September 30, 2020 and December 31, 2019, respectively, and are included in impaired loans. The Company has granted, in its TDRs, a variety of concessions to borrowers in the form of loan modifications. The modifications granted can generally be described in the following categories:

Rate Modification: A modification in which the interest rate is changed.

Term Modification: A modification in which the maturity date, timing of payments or frequency of payments is changed.

Payment Modification: A modification in which the dollar amount of the payment is changed. Interest only modifications in which a loan is converted to interest only payments for a period of time are included in this category.

Combination Modification: Any other type of modification, including the use of multiple categories above.

There was one loan totaling $146,000 modified as a TDR during the three months ended September 30, 2020 and four loans totaling $795,000 modified as TDRs during the nine months ended September 30, 2020. One TDR loan totaling $161,000 was paid-off during the three months ended September 30, 2020 and two TDR loan totaling $2.9 million were paid-off during the nine months ended September 30, 2020. There were four loans totaling $5.1 million modified as TDRs during the three and nine months ended September 30, 2019. There were no TDR loans paid off during the three months ended September 30, 2019, and three TDR loans totaling $145,000 were paid-off during the nine months ended September 30, 2019.

There were no post-modification changes for the unpaid principal balance in loans, net of partial charge-offs, that were recorded as a result of the TDRs for the three and nine months ended September 30, 2020 and 2019. There was one loan totaling $161,000 modified as a TDR for which there was a payment default within the first 12 months of modification during the nine months ended September 30, 2020. During the nine months ended September 30, 2019, there was one loan totaling $97,000 modified as TDRs for which there was a payment default within the first 12 months of modification.

The Company had no commitments to extend additional credit to borrowers owing receivables whose terms have been modified into TDRs.

In March 2020, the Company began offering short-term loan modifications to assist borrowers during the COVID-19 pandemic. The CARES Act and related bank regulatory guidance provides that a short-term modification made in response to COVID-19 and which meets certain criteria does not need to be accounted for as a TDR. As of September 30, 2020, we have provided payment relief related to COVID-19 on 49 commercial loans totaling $37.4 million and 72 residential loans totaling $16.3 million, of which 12 commercial loans totaling $14.7 million and 25 residential loans totaling $4.7 million have resumed their normal loan payments or matured. There were $34.3 million of loans still under payment relief at September 30, 2020. Accordingly, the Company does not account for such loan modifications as TDRs. Loan modifications in accordance with the CARES Act and related regulatory guidance are still subject to an evaluation in regard to determining whether or not a loan is deemed to be impaired. See “Note 2 – Accounting Pronouncements Recently Issued or Adopted”.

Note 5 – Fair Value Measurements

The Company determines the fair values of its financial instruments based on the requirements established in Accounting Standards Codification (“ASC”) 820, Fair Value Measurements, which provides a framework for measuring fair value in accordance with U.S. GAAP and requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. ASC 820 defines fair values for financial instruments as the exit price, the price that would be received for an asset or paid to transfer a liability, in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date under current market conditions. The Company’s fair values for financial instruments at September 30, 2020 were determined based on these requirements.

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

Cash and cash equivalents - The estimated fair value is equal to the carrying amount.

Treasury Bills - The estimated fair value is equal to the carrying amount.

Available-for-Sale Securities – Available-for-sale securities are recorded at fair value based on quoted market prices, if available. If quoted market prices are not available, management utilizes third-party pricing services or broker quotations from dealers in the specific instruments. Level 2 securities include those traded on an active exchange, as well as U.S. government securities.

Loans Held-for-Sale - Residential mortgage loans held-for-sale are recorded at the lower of cost or fair value. The fair value of fixed-rate residential loans is based on whole loan forward prices obtained from government sponsored enterprises. At September 30, 2020 and December 31, 2019, loans held-for-sale were carried at cost, as no impairment was required.

Loans Held-for-Portfolio - The estimated fair value of loans-held-for portfolio consists of a credit adjustment to reflect the estimated adjustment to the carrying value of the loans due to credit-related factors and a yield adjustment, to reflect the estimated adjustment to the carrying value of the loans due to a differential in yield between the portfolio loan yields and estimated current market rate yields on loans with similar characteristics. The estimated fair values of loans held for portfolio reflect exit price assumptions. The liquidity premium/discounts are part of the valuation for exit pricing.

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

FHLB stock - The estimated fair value is equal to the par value of the stock.

Non-maturity deposits - The estimated fair value is equal to the carrying amount.

Time deposits - The estimated fair value of time deposits is based on the difference between interest costs paid on the Company’s time deposits and current market rates for time deposits with comparable characteristics.

Borrowings - The fair value of borrowings are estimated using the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

Subordinated Debt - The fair value of subordinated debt is estimated using discounted cash flows based on current lending rates for similar long-term debt instruments with similar terms and remaining time to maturity.

A description of the valuation methodologies used for impaired loans and OREO is as follows:

Impaired Loans - The fair value of collateral dependent loans is based on the current appraised value of the collateral less estimated costs to sell, or internally developed models utilizing a calculation of expected discounted cash flows which contain management’s assumptions.

OREO and Repossessed Assets – The fair value of OREO and repossessed assets is based on the current appraised value of the collateral less estimated costs to sell.

Off-balance sheet financial instruments - The fair value for the Company’s off-balance sheet loan commitments are estimated based on fees charged to others to enter into similar agreements taking into account the remaining terms of the agreements and credit standing of the Company’s clients. The estimated fair value of these commitments is not significant.

The following tables present information about the level in the fair value hierarchy for the Company’s financial assets and liabilities, whether or not recognized or recorded at fair value as of September 30, 2020 and December 31, 2019 (in thousands):


	September 30, 2020				Fair Value Measurements Using:
	Carrying Value		Estimated Fair Value		Level 1		Level 2		Level 3
FINANCIAL ASSETS:
Cash and cash equivalents	$	115,762	$	115,762	$	115,762	$	—	$	—
Available-for-sale securities	13,296		13,296		—		13,296		—
Loans held-for-sale	16,063		16,063		—		16,063		—
Loans held-for-portfolio, net	683,446		689,125		—		—		689,125
Mortgage servicing rights	3,339		3,339		—		—		3,339
FHLB stock	1,164		1,164		—		1,164		—
FINANCIAL LIABILITIES:
Non-maturity deposits	507,812		507,812		—		507,812		—
Time deposits	241,038		245,062		—		245,062		—
Borrowings	7,500		7,500		—		7,500		—
Subordinated debt	11,676		11,676		—		11,676		—


	December 31, 2019				Fair Value Measurements Using:
	Carrying Value		Estimated Fair Value		Level 1		Level 2		Level 3
FINANCIAL ASSETS:
Cash and cash equivalents	$	55,770	$	55,770	$	55,770	$	—	$	—
Available-for-sale securities	9,306		9,306		—		9,306		—
Loans held-for-sale	1,063		1,063		—		1,063		—
Loans held-for-portfolio, net	614,247		622,147		—		—		622,147
Mortgage servicing rights	3,239		3,239		—		—		3,239
FHLB stock	1,160		1,160		—		1,160		—
FINANCIAL LIABILITIES:
Non-maturity deposits	365,331		365,331		—		365,331		—
Time deposits	251,387		255,261		—		255,261		—
Borrowings	7,500		7,500		—		7,500		—

The following tables present the balance of assets measured at fair value on a recurring basis as of September 30, 2020 and December 31, 2019 (in thousands):


	Fair Value at September 30, 2020
Description	Total		Level 1		Level 2		Level 3
Treasury bills	$	1,976	$	1,976	$	—	$	—
Municipal bonds	5,253		—		5,253		—
Agency mortgage-backed securities	6,067		—		6,067		—
Mortgage servicing rights	3,339		—		—		3,339


	Fair Value at December 31, 2019
Description	Total		Level 1		Level 2		Level 3
Municipal bonds	$	3,370	$	—	$	3,370	$	—
Agency mortgage-backed securities	5,936		—		5,936		—
Mortgage servicing rights	3,239		—		—		3,239

The following tables provide a description of the valuation technique, unobservable input, and qualitative information about the unobservable inputs for the Company’s assets and liabilities classified as Level 3 and measured at fair value on a recurring basis at September 30, 2020 and December 31, 2019:

September 30, 2020

Financial Instrument

Valuation Technique

Unobservable Input(s)

Range
(Weighted-Average)

Mortgage Servicing Rights

Discounted cash flow

Prepayment speed assumption

168%-265% (244%)

Discount rate

10%-12% (10.1%)

December 31, 2019

Financial Instrument

Valuation Technique

Unobservable Input(s)

Range
(Weighted-Average)

Mortgage Servicing Rights

Discounted cash flow

Prepayment speed assumption

132%-485% (187%)

Discount rate

12.5%-13.5% (12.5%)

Generally, any significant increases in the constant prepayment rate and discount rate utilized in the fair value measurement of the mortgage servicing rights will result in a negative fair value adjustment (and decrease in the fair value measurement). Conversely, a decrease in the constant prepayment rate and discount rate will result in a positive fair value adjustment (and increase in the fair value measurement). An increase in the weighted average life assumptions will result in a decrease in the constant prepayment rate and conversely, a decrease in the weighted-average life will result in an increase of the constant prepayment rate.

There were no assets or liabilities (excluding mortgage servicing rights) measured at fair value using significant unobservable inputs (Level 3) on a recurring basis during the three and nine months ended September 30, 2020 and September 30, 2019.

Mortgage servicing rights are measured at fair value using a significant unobservable input (Level 3) on a recurring basis - additional information is included in Note 6 – Mortgage Servicing Rights.

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


	Fair Value at September 30, 2020
	Total		Level 1		Level 2		Level 3
OREO and repossessed assets	$	575	$	—	$	—	$	575
Impaired loans	9,118		—		—		9,118


	Fair Value at December 31, 2019
	Total		Level 1		Level 2		Level 3
OREO and repossessed assets	$	575	$	—	$	—	$	575
Impaired loans	12,393		—		—		12,393

There were no liabilities carried at fair value, measured on a recurring or nonrecurring basis, at September 30, 2020 and December 31, 2019.

The following tables provide a description of the valuation technique, observable input, and qualitative information about the unobservable inputs for the Company’s assets and liabilities classified as Level 3 and measured at fair value on a nonrecurring basis at September 30, 2020 and December 31, 2019:

September 30, 2020

Financial
Instrument

Valuation Technique(s)

Unobservable Input(s)

Range (Weighted Average)

OREO

Market approach

Adjustment for differences
between comparable sales

0-0% (0%)

Impaired loans

Market approach

Adjustment for differences
between comparable sales

0-100% (4.9%)

December 31, 2019

Financial
Instrument

Valuation Technique(s)

Unobservable Input(s)

Range
(Weighted Average)

OREO

Market approach

Adjusted for difference
between comparable sales

0-0% (0%)

Impaired loans

Market approach

Adjusted for difference
between comparable sales

0-100% (6%)

Note 6 – Mortgage Servicing Rights

The Company’s mortgage servicing rights portfolio totaled $444.3 million at September 30, 2020 compared to $377.3 million at December 31, 2019. Of this total balance, the unpaid principal balance of loans serviced for Federal National Mortgage Association (“Fannie Mae”) at September 30, 2020 and December 31, 2019 were $433.2 million and $363.3 million, respectively. The unpaid principal balance of loans serviced for other financial institutions at September 30, 2020 and December 31, 2019, totaled $11.1 million and $14.0 million, respectively. Loans serviced for others are not included in the Company’s financial statements as they are not assets of the Company.

A summary of the change in the balance of mortgage servicing assets during the three and nine months ended September 30, 2020 and 2019 were as follows (in thousands):


	Three Months Ended September 30,				Nine Months Ended September 30,
	2020		2019		2020		2019
Beginning balance, at fair value	$	3,113	$	3,205	$	3,239	$	3,414
Servicing rights that result from transfers and sale of financial assets	849		111		1,523		388
Changes in fair value:
Due to changes in model inputs or assumptions and other(1)	(623)		(90)		(1,423)		(576)

Ending balance, at fair value	$	3,339	$	3,226	$	3,339	$	3,226

(1) Represents changes due to collection/realization of expected cash flows and curtailments.

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


	September 30, 2020		December 31, 2019
Prepayment speed (Public Securities Association “PSA” model)	244	%	187	%
Weighted-average life	5.2 years		6.2 years
Discount rate	10.1	%	12.5	%

The amount of contractually specified servicing, late and ancillary fees earned on the mortgage servicing rights are included in

mortgage servicing income on the Condensed Consolidated Statements of Income and totaled $260,000 and $739,000 for the three and nine months ended September 30, 2020, respectively, and $259,000 and $756,000 for the three and nine months ended September 30, 2019, respectively.

Table of Contents

Note 7 – Commitments and Contingencies

In the normal course of operations, the Company engages in a variety of financial transactions that are not recorded in our financial statements. These transactions involve varying degrees of off-balance sheet credit, interest rate and liquidity risks. These transactions are used primarily to manage clients’ requests for funding and take the form of loan commitments and lines of credit.

Note 8 – Borrowings, FHLB Stock and Subordinated Debt

The Company utilizes a loan agreement with the FHLB of Des Moines. The terms of the agreement call for a blanket pledge of a portion of the Company’s mortgage and commercial and multifamily loan portfolio based on the outstanding balance. At September 30, 2020 and December 31, 2019, the amount available to borrow under this credit facility was $392.3 million and $321.9 million, respectively, subject to eligible pledged collateral. At September 30, 2020, the credit facility was collateralized as follows: one-to-four family mortgage loans with an advance equivalent of $96.8 million, commercial and multifamily mortgage loans with an advance equivalent of $126.2 million and home equity loans with an advance equivalent of $3.7 million. At December 31, 2019, the credit facility was collateralized as follows: one-to-four family mortgage loans with an advance equivalent of $111.4 million, commercial and multifamily mortgage loans with an advance equivalent of $126.1 million and home equity loans with an advance equivalent of $6.9 million. The Company had outstanding borrowings under this arrangement of $7.5 million at both September 30, 2020 and December 31, 2019. The weighted-average interest rate of our borrowings was 3.05% at both September 30, 2020 and December 31, 2019. Additionally, the Company had outstanding letters of credit from the FHLB of Des Moines with a notional amount of $20.6 million and $19.1 million at September 30, 2020 and December 31, 2019, respectively, to secure public deposits. The remaining amount available to borrow as of September 30, 2020 and December 31, 2019, was $198.6 million and $217.8 million, respectively.

As a member of the FHLB, the Company is required to maintain a minimum level of investment in FHLB of Des Moines stock based on specific percentages of its outstanding FHLB advances. At September 30, 2020 and December 31, 2019, the Company had an investment of $1.2 million in FHLB of Des Moines stock.

The Company participates in the Federal Reserve Bank Borrower-in-Custody program, which gives the Company access to the discount window and the Paycheck Protection Program Liquidity Facility (“PPPLF”). The terms of both programs call for a pledge of specific assets. The Company pledges commercial and consumer loans as collateral for this borrower-in-custody line of credit and PPP loans for the PPPLF. The Company had unused borrowing capacity of $29.4 million and $41.7 million and no outstanding borrowings under these programs at September 30, 2020 and December 31, 2019, respectively.

The Company has access to an unsecured Fed Funds line of credit from Pacific Coast Banker’s Bank. The line has a 1 year term maturing on June 30, 2021 and is renewable annually. As of September 30, 2020, the amount available under this line of credit was $10.0 million. There was no balance on this line of credit as of September 30, 2020 and December 31, 2019, respectively.

The Company has access to an unsecured Fed Funds line of credit from The Independent Bank. As of September 30, 2020, the amount available under this line of credit was $10.0 million. The agreement may be terminated by either party. There was no balance on this line of credit as of September 30, 2020 and December 31, 2019, respectively.

The Company completed a private placement of $12.0 million in aggregate principal amount of 5.25% Fixed-to-Floating Rate Subordinated Notes due 2030 resulting in net proceeds, after placement fees and offering expenses, of approximately $11.7 million during the quarter ended September 30, 2020. The Company contributed $5.5 million of the net proceeds from the sale of the Notes to the Bank and intends to use the remaining net proceeds from the sale of the notes for general corporate purposes, including stock repurchases and to pay dividends on Company common stock.

Note 9 – Earnings Per Common Share

Basic earnings per common share is computed by dividing net income available to common shareholders by the weighted-average number of common shares outstanding for the period, reduced for average unallocated ESOP shares and average unvested restricted stock awards. Unvested share-based awards containing non-forfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and are included in the computation of earnings per share pursuant to the two-class method. Diluted earnings per common share reflect the potential dilution that could occur if securities or other contracts to issue common stock (such as stock awards and options) were exercised or converted to common stock or resulted in the issuance of common stock that then shared in the Company’s earnings. Diluted earnings per common share is

computed by dividing net income by the weighted-average number of common shares outstanding for the period increased for the dilutive effect of unexercised stock options and unvested restricted stock awards. The dilutive effect of the unexercised stock options and unvested restricted stock awards is calculated under the treasury stock method utilizing the average market value of the Company's stock for the period.

The following table summarizes the calculation of earnings per share for the periods indicated (in thousands, except per share data):


	Three Months Ended September 30,				Nine Months Ended September 30,
	2020		2019		2020		2019
Net income available to common shareholders	$	2,319	$	1,548	$	5,407	$	4,809
Weighted-average number of shares outstanding, basic	2,563		2,526		2,558		2,521
Effect of potentially dilutive common shares	26		52		30		51
Weighted-average number of shares outstanding, diluted	2,589		2,578		2,588		2,572
Earnings per share, basic	$	0.90	$	0.61	$	2.11	$	1.90
Earnings per share, diluted	$	0.90	$	0.60	$	2.09	$	1.87

There were 19,281 anti-dilutive securities at September 30, 2020 and no anti-dilutive securities at September 30, 2019.

Note 10 – Stock-based Compensation

Stock Options and Restricted Stock

The Company currently has one active shareholder approved Equity Incentive Plan, the Amended and Restated 2013 Equity Incentive Plan (the "2013 Plan"). The 2013 Plan permits the grant of restricted stock, restricted stock units, stock options, and stock appreciation rights. The equity incentive plan approved by stockholders in 2008 (the"2008 Plan") expired in November 2018 and no further awards may be made under the 2008 Plan; provided, however, all awards outstanding under the 2008 Plan remain outstanding in accordance with their terms. Under the 2013 Plan, 181,750 shares of common stock were approved for awards for stock options and stock appreciation rights and 116,700 shares of common stock were approved for awards for restricted stock and restricted stock units.

As of September 30, 2020, on an adjusted basis, awards for stock options totaling 261,019 shares and awards for restricted stock totaling 134,148 shares of Company common stock have been granted, net of any forfeitures, to participants in the 2013 Plan and the 2008 Plan. Share-based compensation expense was $52,000 and $283,000 for the three and nine months ended September 30, 2020, respectively, and was $72,000 and $159,000 or the three and nine months ended September 30, 2019, respectively.

Stock Option Awards

All stock option awards granted under the 2008 Plan vest in 20 percent annual increments commencing one year from the grant date in accordance with the requirements of the 2008 Plan. The stock option awards granted to date under the 2013 Plan provide

for immediate vesting of a portion of the award with the balance of the award vesting on the anniversary date of each grant date

in equal annual installments over periods of one-to-four years subject to the continued service of the participant with the

Company. All of the options granted under the 2008 Plan and the 2013 Plan are exercisable for a period of 10 years from the date of grant, subject to vesting. The following is a summary of the Company’s stock option award activity during the nine months ended September 30, 2020:


	Shares	Weighted- Average Exercise Price		Weighted-Average Remaining Contractual Term in Years	Aggregate Intrinsic Value
Outstanding at January 1, 2020	121,260	$	20.80	5.33	$	1,842,687
Granted	8,225	36.26
Exercised	(19,413)	17.22
Forfeited	(2,205)	29.25
Expired	(6,733)	28.96
Outstanding at September 30, 2020	101,134	22.02		4.97	873,423
Exercisable	85,334	19.99		4.36	851,612
Expected to vest, assuming a 0% forfeiture rate over the vesting term	14,099	$	34.96	8.75	$	—

As of September 30, 2020, there was $82,000 of total unrecognized compensation cost related to non-vested stock options granted under the Plans. The cost is expected to be recognized over the remaining weighted-average vesting period of approximately 2.83 years.

The fair value of each option grant is estimated as of the grant date using the Black-Scholes option-pricing model. The fair value of options granted for the nine months ended September 30, 2020 and 2019 were determined using the following weighted-average assumptions as of the grant date.


	September 30, 2020			September 30, 2019
Annual dividend yield	1.60		%	1.72		%
Expected volatility	21.67		%	21.68		%
Risk-free interest rate	1.38		%	2.64		%
Expected term	6.50 years			6.50 years
Weighted-average grant date fair value per option granted	$	7.14		$	7.24

Restricted Stock Awards

The fair value of the restricted stock awards is equal to the fair value of the Company's stock at the date of grant. Compensation

expense is recognized over the vesting period that the awards are based. The restricted stock awards granted under the 2008

Plan vest in 20% annual increments commencing one year from the grant date. The restricted stock awards granted to date under the 2013 Plan provide for immediate vesting of a portion of the award with the balance of the award vesting on the anniversary date of each of the grant date in equal annual installments over periods of one-to-four years subject to the continued service of the participant with the Company.

The following is a summary of the Company’s non-vested restricted stock award activity during the nine months ended September 30, 2020:


	Shares	Weighted-Average Grant-Date Fair Value Per Share		Aggregate Intrinsic Value Per Share
Non-vested at January 1, 2020	12,290	$	33.32
Granted	13,600	36.26
Vested	(6,816)	34.60
Forfeited	(1,690)	34.15

Non-Vested at September 30, 2020	17,384	$	35.03	$	29.63
Expected to vest assuming a 0% forfeiture rate over the vesting term	17,384	$	35.03	$	29.63

As of September 30, 2020, there was $490,000 of unrecognized compensation cost related to non-vested restricted stock granted under the Plans. The cost is expected to be recognized over the weighted-average vesting period of 2.87 years. The total fair value of shares vested for the nine months ended September 30, 2020 and 2019 was $236,000 and $365,000, respectively.

Employee Stock Ownership Plan

In January 2008, the ESOP borrowed $1.2 million from the Company to purchase common stock of the Company which was paid in full in 2017. In August 2012, in conjunction with the Company’s conversion to a full stock company from the mutual holding company structure, the ESOP borrowed an additional $1.1 million from the Company to purchase common stock of the Company. The loan is being repaid principally by the Bank through contributions to the ESOP over a period of ten years. The interest rate on the loan is fixed at 2.25% per annum. As of September 30, 2020, the remaining balance of the ESOP loan was $126,000.

Neither the loan balance nor the related interest expense is reflected on the condensed consolidated financial statements.

For the calendar year 2020, the ESOP was committed to release 11,340 shares of the Company’s common stock to participants and held 11,340 unallocated shares remaining to be released in 2021. The fair value of the 140,679 shares held by the ESOP trust was $4.2 million at September 30, 2020. ESOP compensation expense included in salaries and benefits was $126,000 and $474,000 for the three and nine months ended September 30, 2020, respectively, and was $168,000 and $504,000 for the three and nine months ended September 30, 2019, respectively.

Note 11 – Revenue from Contracts with Customers

All of the Company's revenue from contracts with customers in the scope of ASC 606 - Revenue from Contracts with Customers ("ASC 606") is recognized in Noninterest Income with the exception of the net loss on OREO and repossessed assets, which is included in Noninterest Expense. The following table presents the Company's sources of Noninterest Income for the three and nine months ended September 30, 2020 and 2019 (in thousands). Items outside of the scope of ASC 606 are noted as such.


	Three Months Ended September 30,				Nine Months Ended September 30,
	2020		2019		2020		2019
Noninterest income:
Service charges and fee income
Account maintenance fees	$	74	$	48	$	209	$	143
Transaction-based and overdraft service charges	74		118		235		338
Debit/ATM interchange fees	270		264		742		728
Credit card interchange fees	5		7		18		21
Loan fees (a)	72		59		183		163
Other fees (a)	15		16		46		44
Total service charges and fee income	510		512		1,433		1,437
Earnings on cash surrender value of bank-owned life insurance (a)	102		81		207		267
Mortgage servicing income (a)	260		259		739		756
Fair value adjustment on mortgage servicing rights (a)	(623)		(90)		(1,423)		(576)
Net gain on sale of loans (a)	1,819		305		3,399		1,000

Total noninterest income	$	2,068	$	1,067	$	4,355	$	2,884

(a) Not within scope of Topic 606

Account maintenance fees and transaction-based and overdraft service charges

The Company earns fees from its customers for account maintenance, transaction-based and overdraft services. Account maintenance fees consist primarily of account fees and analyzed account fees charged on deposit accounts on a monthly basis. The performance obligation is satisfied and fees are recognized on a monthly basis as the service period is completed. Transaction-based fees and overdraft service fees on deposit accounts are charged to deposit customers for specific services provided to the customer, such as non-sufficient funds, overdraft, and wire services. The performance obligation is completed as the transaction occurs and the fees are recognized at the time each specific service is provided to the customer.

Debit/ATM and credit card interchange income

Debit/ATM interchange income represent fees earned when a debit card issued by the Bank is used for a transaction. The Bank earns interchange fees from debit cardholder transactions through the MasterCard payment network. Interchange fees from cardholder transactions represent a percentage of the underlying transaction value and are recognized daily, concurrently with the transaction processing services provided to the cardholder. The performance obligation is satisfied and the fees are earned when the cost of the transaction is charged to the cardholders' account. Certain expenses directly associated with the debit card are recorded on a net basis with the interchange income.

The Company utilizes a third-party agency relationship to brand credit cards with fees for originating new accounts paid by the issuing bank. Credit card interchange income represents fees earned when a credit card is issued by the third-party agent. Similar to debit card interchange fees, the Bank earns an interchange fee for each transaction made with Sound Community Bank's branded credit cards. The performance obligation is satisfied and the fees are earned when the cost of the transaction is charged to the cardholders' credit card. Certain expenses and rebates directly related to the credit card interchange contract are recorded net of the interchange income.

Net loss on OREO and repossessed assets

We record a gain or loss from the sale of other real estate owned when control of the property transfers to the buyer, which generally occurs at the time of an executed deed of trust. When the Bank finances the sale of other real estate owned to the buyer, the Company assesses whether the buyer is committed to perform their obligations under the contract and whether collectability of the transaction price is probable. Once these criteria are met, the other real estate owned asset is derecognized and the gain or loss on sale is recorded upon the transfer of control of the property to the buyer. In determining the gain or loss on sale, we adjust the transaction price and related gain or loss on sale if a significant financing component is present. The

Company incurred no expenses on OREO properties for the three and nine months ended September 30, 2020, compared to $1,000 and $11,000 for the three and nine months ended 2019, respectively, which are included in Noninterest Expense on the Company’s Condensed Consolidated Statements of Income.

Note 12 – Leases

We have operating leases for branch locations, a loan production office, our corporate office and certain equipment. The lease term for our leases begins on the date we become legally obligated for the rent payments or we take possession of the building, whichever is earlier. Generally, our real estate leases have initial terms of three to 10 years and typically include one renewal option. Our leases have remaining lease terms of 1 year to 10 years. The operating leases generally contain renewal options and require us to pay property taxes and operating expenses for the properties.

The following table represents the lease right-of-use assets and lease liabilities recorded on the condensed consolidated balance sheet at September 30, 2020 and December 31, 2019 (in thousands):


	September 30, 2020		December 31, 2019
Operating lease right-of-use assets	$	6,945	$	7,641
Operating lease liabilities	$	7,348	$	8,010

The following table represents the components of lease expense (in thousands):


	Three Months Ended September 30,				Nine Months Ended September 30,
	2020		2019		2020		2019
Operating lease expense
Office leases	$	268	$	306	$	882	$	916
Equipment leases	5		5		15		15
Sublease income	(3)		(3)		(9)		(9)
Net lease expense	$	270	$	308	$	888	$	922

The following table represents the maturity of lease liabilities:


	September 30, 2020
	Office leases		Equipment leases
Operating Lease Commitments
Remainder of 2020	$	257	$	5
2021	1,042		20
2022	1,017		9
2023	989		—
2024	968		—
Thereafter	3,897		—
Total lease payments	8,170		34
Less: Present value discount	856		—
Present value of lease liabilities	$	7,314	$	34

Lease term and discount rate by lease type consist of the following:


	September 30, 2020
Weighted-average remaining lease term (in years):
Office leases	8.11
Equipment leases	1.67
Weighted-average discount rate (annualized):
Office leases	2.65	%
Equipment leases	1.62	%

Supplemental cash flow information related to leases was as follows (in thousands):


	Three Months Ended September 30,				Nine Months Ended September 30,
	2020		2019		2020		2019
Cash paid for amounts included in the measurement of lease liabilities for operating leases:
Operating cash flows
Office leases	$	257	$	290	$	839	$	808
Equipment leases	$	5	$	5	$	15	$	15

Table of Contents

Note 13 – Subsequent Event

On October 27, 2020, the Board of Directors of the Company declared a quarterly cash dividend of $0.15 per common share, payable on November 24, 2020 to stockholders of record at the close of business on November 10, 2020.

On October 27, 2020, the Company announced that its Board of Directors authorized a stock repurchase program. Under this repurchase program, the Company may repurchase its outstanding shares in the open market in an amount up to $2.0 million, based on prevailing market prices, or in privately negotiated transactions, over a period beginning on October 28, 2020, continuing until the earlier of the completion of the repurchase or the next six months, depending upon market conditions.

The Company’s Board of Directors also authorized management to enter into a trading plan with a registered broker-dealer in

accordance with Rule 10b5-1 of the Securities Exchange Act of 1934, as amended, to facilitate repurchases of its common

stock pursuant to the above mentioned stock repurchase program.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operation

MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Special Note Regarding Forward-Looking Statements

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

•the effect of the novel coronavirus disease 2019 (“COVID-19”) pandemic, including on our credit quality and business operations, as well as its impact on general economic and financial market conditions and other uncertainties resulting from the COVID-19 pandemic, such as the extent and duration of the impact on public health, the U.S. and global economies, and consumer and corporate clients, including economic activity, employment levels and market liquidity;

•changes in consumer spending, borrowing and savings habits;

•changes in economic conditions, either nationally or in our market area;

•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;

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

•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;

•our ability to access cost-effective funding;

•uncertainty regarding the future of the London Interbank Offered Rate ("LIBOR"), and the potential transition away from LIBOR toward new interest rate benchmarks;

•our ability to control operating costs and expenses;

•secondary market conditions for loans and our ability to sell loans in the secondary market;

•fluctuations in interest rates;

•results of examinations of Sound Financial Bancorp and Sound Community Bank by their regulators, including the possibility that the regulators may, among other things, require us to increase our allowance for loan losses or to write-down assets, change Sound Community Bank's regulatory capital position or affect our ability to borrow funds or maintain or increase deposits, which could adversely affect our liquidity and earnings;

•inability of key third-party providers to perform their obligations to us;

•our ability to attract and retain deposits;

•competitive pressures among financial services companies;

•our ability to successfully integrate any assets, liabilities, clients, 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;

•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;

•our ability to keep pace with technological changes, including our ability to identify and address cyber-security risks such as data security breaches, "denial of service" attacks, "hacking" and identity theft, and other attacks on our information technology systems or on the third-party vendors who perform several of our critical processing functions;

•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;

•legislative or regulatory changes such as the Dodd-Frank Wall Street Reform and Consumer Protection Act and its implementing regulations that adversely affect our business, and the availability of resources to address such changes;

•our ability to retain or attract key employees or members of our senior management team;

•costs and effects of litigation, including settlements and judgments;

•our ability to implement our business strategies;

•staffing fluctuations in response to product demand or the implementation of corporate strategies that affect our workforce and potential associated charges;

•our ability to pay dividends on our common stock;

•the possibility of other-than-temporary impairments of securities held in our securities portfolio;

•other economic, competitive, governmental, regulatory, and technological factors affecting our operations, pricing, products and services, including the Coronavirus Aid, Relief, and Economic Security Act of 2020 ("CARES Act"); and

•the other risks described from time to time in our filings with the U.S. Securities and Exchange Commission (the "SEC"), including this Form 10-Q and our Annual Report on Form 10-K for the year ended December 31, 2019 (“2019 Form 10-K”).

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.

General

Sound Financial Bancorp, a Maryland corporation, is a bank holding company for its wholly owned subsidiary, Sound Community Bank. Substantially all of Sound Financial Bancorp’s business is conducted through Sound Community Bank, a Washington state-chartered commercial bank. As a Washington commercial bank, the Bank’s regulators are the Washington Department of Financial Institutions and the Federal Deposit Insurance Corporation (the “FDIC”). The Federal Reserve is the primary federal regulator for Sound Financial Bancorp. We also sell insurance products and services for clients through Sound Community Insurance Agency, Inc., a wholly owned subsidiary of the Bank.

Sound Community Bank’s deposits are insured up to applicable limits by the FDIC. At September 30, 2020, Sound Financial Bancorp, on a consolidated basis, had assets of $867.4 million, net loans held-for-portfolio of $683.4 million, deposits of $748.9 million and stockholders’ equity of $82.3 million. The shares of Sound Financial Bancorp are traded on NASDAQ Capital Market under the symbol “SFBC.” Our executive offices are located at 2400 3rd Avenue, Suite 150, Seattle, Washington, 98121.

Our principal business consists of attracting retail and commercial deposits from the general public and investing those funds, along with borrowed funds, in loans secured by first and second mortgages on one- to four- family residences (including home equity loans and lines of credit), commercial and multifamily real estate, construction and land, consumer and commercial business loans. Our commercial business loans include unsecured lines of credit and secured term loans and lines of credit secured by inventory, equipment and accounts receivable. We also offer a variety of secured and unsecured consumer loan products, including manufactured home loans, floating home loans, automobile loans, boat loans and recreational vehicle

loans. As part of our business, we focus on residential mortgage loan originations, a significant portion of which we sell to Fannie Mae and other correspondents and the remainder of which we retain for our loan portfolio consistent with our asset/liability objectives. We sell loans which conform to the underwriting standards of Fannie Mae (“conforming”) in which we retain the servicing of the loan in order to maintain the direct customer relationship and to generate noninterest income. Residential loans which do not conform to the underwriting standards of Fannie Mae (“non-conforming”), are either held in our loan portfolio or sold with servicing retained. We originate and retain a significant amount of commercial real estate loans, including those secured by owner-occupied and nonowner-occupied commercial real estate, multifamily property, mobile home parks and construction and land development loans.

Critical Accounting Policies

Certain of our accounting policies require management to make difficult, complex or subjective judgments, which may relate to matters that are inherently uncertain. Estimates associated with these policies are susceptible to material changes as a result of changes in facts and circumstances. Facts and circumstances that could affect these judgments include, but are not limited to, changes in interest rates, changes in the performance of the economy and changes in the financial condition of borrowers. Management believes that its critical accounting policies include determining the allowance for loan losses, accounting for other-than-temporary impairment of securities, accounting for mortgage servicing rights, accounting for other real estate owned and accounting for deferred income taxes. Our methodologies for analyzing the allowance for loan losses, other-than-temporary impairment, mortgage servicing rights, other real estate owned and deferred tax asset accounts are described in our 2019 Form 10-K.

COVID 19 Response

In response to the COVID-19 pandemic, the Company is offering a variety of relief options designed to support our clients and communities we serve.

Paycheck Protection Program ("PPP") Participation. The CARES Act was signed into law on March 27, 2020, and authorized the Small Business Administration (“SBA”) to temporarily guarantee loans under a loan program called the Paycheck Protection Program, or PPP. As a qualified SBA lender, the Company was automatically authorized to originate PPP loans upon commencement of the program in April 2020. PPP loans have: (a) an interest rate of 1.0%, (b) a two-year loan term to maturity; and (c) principal and interest payments deferred for six months from the date of disbursement. The SBA guarantees 100% of the PPP loans made to eligible borrowers. The entire principal amount of the borrower’s PPP loan, including any accrued interest, is eligible to be forgiven and repaid by the SBA. The deadline for PPP loan applications to the SBA was extended to August 8, 2020.

Through the conclusion of the PPP on August 8, 2020, we have funded $74.8 million in PPP loans, with an average loan amount of $82,000. Many of the PPP applications have been from our existing clients but we are also serving those in our communities who have not had a banking relationship with us in the past. In addition to the 1% interest earned on these loans, the SBA pays us fees for processing PPP loans in the following amounts: (i) 5% for loans of not more than $350,000; (ii) 3% for loans of more than $350,000 and less than $2,000,000; and (iii) 1% for loans of at least $2,000,000. We may not collect any fees from the loan applicants. The following table summarizes our PPP participation as of September 30, 2020 (dollars in thousands):


	Funded
	Total Outstanding		Number of Loans	Average Loan Amount
Existing clients	$	31,555	363	$	87
New clients	43,221		546	79
Total PPP loans	$	74,776	909	$	82

The SBA processing fees for the approved loans totaled $2.9 million at September 30, 2020.

Loan Modifications. We are providing payment relief for both consumer and business clients due to the COVID-19 pandemic. As of September 30, 2020, we have provided payment relief related to COVID-19, in accordance with the CARES Act, on 49 commercial loans totaling $37.4 million and 72 residential loans totaling $16.3 million, of which 12 commercial loans totaling $14.7 million and 25 residential loans totaling $4.7 have resumed their normal loan payments or matured. The $34.3 million of loans under payment relief at September 30, 2020, include 26 residential loans totaling $9.2 million that have entered into a second payment forbearance agreement and eight residential loans totaling $808,000 with a weighted average loan-to value of 76% that have entered into a third payment forbearance agreement. All loans modified due to the COVID-19 pandemic will be separately monitored and any request for continuation of relief beyond the initial modification will be reassessed at that time to determine if further modifications should be granted and if a downgrade in risk rating is appropriate. We believe the steps we are taking are necessary to effectively manage our portfolio and assist our clients through the ongoing uncertainty surrounding the duration, impact and government response to the COVID-19 pandemic.

The following is a summary of the type and amount of loan modifications made by the Company as of September 30, 2020 (dollars in thousands):


	Payment Relief
	Interest only						Principal & Interest Forbearance
	90 days		180 days		365 days		90 days		180 days		365 days		Total		% of Total Loans
Real estate loans:
One-to-four family	$	—	$	6,529	$	188	$	911	$	1,594	$	696	$	9,918	1.44	%
Home equity	—		—		—		—		98		84		182		0.03
Construction and land	—		48		—		315		—		—		363		0.05
Commercial and multifamily	2,448		15,841		2,291		—		—		—		20,580		2.99
Total real estate loans	2,448		22,418		2,479		1,226		1,692		780		31,043
Consumer loans:
Manufactured homes	—		—		12		227		509		119		867		0.13
Floating homes	—		—		—		—		249		—		249		0.04
Other consumer loans	—		—		—		—		—		—		—
Total consumer loans	—		—		12		227		758		119		1,116
Commercial business loans	1,350		832		—		—		—		—		2,182		0.32
Total	$	3,798	$	23,250	$	2,491	$	1,453	$	2,450	$	899	$	34,341	4.98	%

The modifications discussed above were not classified as TDRs in accordance with the guidance of the CARES Act and related regulatory banking guidance. The CARES Act provided that the short-term modification of loans as a result of the COVID-19 pandemic, made on a good faith basis to borrowers who were current as defined under the CARES Act prior to any relief, are not TDRs. This includes short-term (up to twelve months) modifications such as payment deferrals, fee waivers, extensions of repayment terms, or other delays in payment that are insignificant. Borrowers are considered current under the CARES Act and related regulatory banking guidance if they are less than 30 days past due on their contractual payments at the time a modification program is implemented and the relief is executed prior to December 31, 2020 or 60 days after the national emergency declared on March 13, 2020 ceases, whichever is earlier.

Support for Clients, Employees and Community during Pandemic. With the continued partial opening of the communities we serve, our retail locations continue to operate with full service and in compliance with various mandates and recommendations including masks, distancing and capacity management. The majority of back office and administrative employees continue to work remotely. We continuously monitor and conform our practices based on updates from the Center for Disease Control, World Health Organization, Financial Regulatory Agencies, and local and state health departments.

We continue to work closely with our borrowers to evaluate pandemic related challenges. We also continue to support our not-for-profit organizations albeit most activity is virtual.

Comparison of Financial Condition at September 30, 2020 and December 31, 2019

General. Total assets increased $147.5 million, or 20.5%, to $867.4 million at September 30, 2020 from $719.9 million at December 31, 2019. The increase was primarily a result of a higher balances in loans held-for-portfolio, cash and cash equivalents, loans held-for-sale, and available-for-sale securities.

Cash and Securities. Cash and cash equivalents increased $60.0 million, or 107.6%, to $115.8 million at September 30, 2020 from $55.8 million at December 31, 2019 primarily due to an increase in deposits, the pay downs in residential loans, including home equity loans and lines of credit, and the proceeds received from the issuance of subordinated debt. Available-for-sale securities, which consist of treasury bills, municipal bonds and agency mortgage-backed securities increased $4.0 million, or 42.9%, to $13.3 million at September 30, 2020 from $9.3 million at December 31, 2019 as a result of investment securities purchased during the year.

Loans. Our loans held-for-portfolio, net, increased $69.2 million, or 11.3%, to $683.4 million at September 30, 2020 from $614.2 million at December 31, 2019, primarily driven by our origination of PPP loans.

The following table reflects the changes in the loan mix of our loan portfolio at September 30, 2020, as compared to December 31, 2019 (dollars in thousands):


	September 30, 2020		December 31, 2019		Amount Change		Percent Change
One-to-four family	$	140,356	$	149,393	$	(9,037)	(6.0)	%
Home equity	17,727		23,845		(6,118)		(25.7)
Commercial and multifamily	275,876		261,268		14,608		5.6
Construction and land	72,166		75,756		(3,590)		(4.7)
Manufactured homes	20,948		20,613		335		1.6
Floating homes	42,399		43,799		(1,400)		(3.2)
Other consumer	12,252		8,302		3,950		47.6
Commercial business	111,025		38,931		72,094		185.2
Deferred loan fees	(3,315)		(2,020)		(1,295)		64.1
Total loans held-for-portfolio, gross	689,434		619,887		69,547		11.2
Allowance for loan losses	(5,988)		(5,640)		(348)		6.2
Total loans held-for-portfolio, net	$	683,446	$	614,247	$	69,199	11.3	%

The largest increase in the loan portfolio was in commercial business loans which increased $72.1 million, or 185.2%, to $111.0 million, at September 30, 2020, compared to $38.9 million at December 31, 2019, driven by our origination of 909 PPP loans totaling $74.8 million at September 30, 2020. PPP loans are 100% guaranteed by the SBA. At September 30, 2020, our loan portfolio, net of deferred loan fees, remained well-diversified. Commercial and multifamily real estate loans accounted for 39.8% of total loans, one-to-four family loans, including home equity loans accounted for 22.8% of total loans, commercial business loans accounted for 16.0% of total loans, and consumer loans, consisting of manufactured homes, floating homes, and other consumer loans accounted for 10.9% of total loans at September 30, 2020. Construction and land loans accounted for 10.4% of total loans at September 30, 2020.

Allowance for Loan Losses. The allowance for loan losses is maintained to cover losses that are probable and can be estimated

on the date of evaluation in accordance with generally accepted accounting principles in the United States. It is our best estimate

of probable credit losses inherent in our loan portfolio. The following table reflects the adjustments in our allowance during the periods indicated (dollars in thousands):


	Three Months Ended September 30,						Nine Months Ended September 30,
	2020			2019			2020			2019
Balance at beginning of period	$	6,031		$	5,370		$	5,640		$	5,774
Charge-offs	(332)			(9)			(649)			(41)
Recoveries	14			7			72			35
Net recoveries/(charge-offs)	(318)			(2)			(577)			(6)
Provision (recapture) for loan losses during the period	275			250			925			(150)
Balance at end of period	$	5,988		$	5,618		$	5,988		$	5,618

Ratio of net recoveries/(charge-offs) during the period to average loans outstanding during the period	—		%	—		%	—		%	—		%


	September 30, 2020		December 31, 2019
Allowance as a percentage of nonperforming loans (end of period)	180.58	%	121.11	%
Allowance as a percentage of total loans (end of period)	0.87	%	0.91	%

Our allowance for loan losses increased $348,000, or 6.2%, to $6.0 million at September 30, 2020, from $5.6 million at December 31, 2019. The increase in provision for loan losses not only reflects probable credit losses based upon the conditions that existed as of September 30, 2020, but also gives consideration to the inherent losses from impacts of the COVID-19 pandemic.

Specific loan loss reserves decreased to $446,000 at September 30, 2020, compared to $724,000 at December 31, 2019, while general loan loss reserves increased to $4.4 million at September 30, 2020, compared to $4.0 million at December 31, 2019 and the unallocated reserve increased to $1.1 million at September 30, 2020, compared to $948,000 at December 31, 2019. The increase in the general reserve was a result of the higher balance on loans held-for-portfolio. Net charge-offs for the three and nine months ended September 30, 2020 were $318,000 and $577,000 respectively, compared to net charge-offs of $2,000 and $6,000 for the three and nine months ended September 30, 2019, respectively. At September 30, 2020, the allowance for loan losses as a percentage of total loans and nonperforming loans was 0.87% and 180.58%, respectively, compared to 0.91% and 121.11%, respectively, at December 31, 2019. The allowance for loan losses to total loans increases 10 basis points when the $74.8 million of PPP loans are excluded from the $689.4 million of total loans at September 30, 2020. PPP loans are fully guaranteed by the SBA and management expects that the great majority of PPP borrowers will seek full or partial forgiveness of their loan obligations from the SBA within a short time frame, which in turn will reimburse the Bank for the amount forgiven.

Mortgage Servicing Rights. The fair value of mortgage servicing rights was $3.3 million at September 30, 2020, an increase of $100,000 or 3.1% from $3.2 million at December 31, 2019. We record mortgage servicing rights on loans sold with servicing retained and upon acquisition of a servicing portfolio. Mortgage servicing rights are carried at fair value. If the fair value of our mortgage servicing rights fluctuates significantly, our financial results could be materially impacted.

Nonperforming Assets. At September 30, 2020, nonperforming assets totaled $3.9 million, or 0.45% of total assets, compared to $5.2 million, or 0.73% of total assets at December 31, 2019.

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


	Nonperforming Assets
	September 30, 2020		December 31, 2019		Amount Change		Percent Change
Nonaccrual loans	$	3,316	$	4,657	$	(1,341)	(28.8)	%
OREO and repossessed assets	575		575		—		—
Total nonperforming assets	$	3,891	$	5,232	$	(1,341)	(25.6)	%

Nonaccrual loans decreased $1.3 million, or 28.8%, to $3.3 million at September 30, 2020 from $4.7 million at December 31, 2019. The percentage of nonaccrual loans to total loans was 0.48% at September 30, 2020, compared to 0.75% of total loans at December 31, 2019.

OREO and repossessed assets were $575,000 at both September 30, 2020 and December 31, 2019. At September 30, 2020, OREO and repossessed assets consisted solely of a former bank branch property located in Port Angeles, Washington which was acquired in 2015 as a part of three branches purchased from another financial institution. It is currently leased to a not-for-profit organization headquartered in our market area at a below market rate.

Deposits. Total deposits increased $132.1 million, or 21.4%, to $748.9 million at September 30, 2020 from $616.7 million at December 31, 2019. The increase was due primarily to disbursements of PPP loan funds into borrowers’ deposit accounts as well as reduced withdrawals reflecting changes in customer spending habits due to the COVID-19 pandemic. We continue our efforts to grow noninterest-bearing deposits, which increased $55.0 million, or 56.5%, to $152.2 million at September 30, 2020, compared to $97.3 million at December 31, 2019.

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


	September 30, 2020				December 31, 2019
	Amount		Wtd. Avg. Rate		Amount		Wtd. Avg. Rate
Noninterest-bearing demand	$	145,870	—	%	$	94,973	—	%
Interest-bearing demand	214,253		0.48		159,774		0.54
Savings	78,549		0.27		57,936		0.33
Money market	62,773		0.40		50,337		0.49
Time deposits	241,038		2.43		251,387		2.23
Escrow (1)	6,367		—		2,311		—
Total deposits	$	748,850	1.06	%	$	616,718	1.16	%

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

Borrowings and subordinated debt. Borrowings, consisting of FHLB advances and subordinated debt increased $11.7 million, to $19.2 million at September 30, 2020 from $7.5 million at December 31, 2019. The increase in borrowing is attributable entirely to our issuance of subordinated debt during the current quarter. During the quarter ended September 30, 2020, the Company completed a private placement of $12.0 million in aggregate principal amount of 5.25% Fixed-to-Floating Rate Subordinated Notes due 2030 (“Notes”) resulting in net proceeds, after placement fees and offering expenses, of approximately $11.7 million. The Company contributed $5.5 million of the net proceeds from the sale of the Notes to the Bank and intends to use the remaining net proceeds for general corporate purposes, including stock repurchases and to pay dividends on Company common stock.

Stockholders’ Equity. Total stockholders’ equity increased $4.6 million, or 5.9%, to $82.3 million at September 30, 2020 from $77.7 million at December 31, 2019. This increase primarily reflects $5.4 million in net income for the nine months ended September 30, 2020, partially offset by the payment of cash dividends of $1.7 million to common stockholders during the nine months ended September 30, 2020.

Comparison of Results of Operation for the Three and Nine Months Ended September 30, 2020 and 2019

General. Net income increased $787,000, or 50.8%, to $2.3 million or $0.90 per diluted common share, for the three months ended September 30, 2020, compared to $1.5 million, or $0.60 per diluted common share, for the three months ended September 30, 2019. Net income increased $634,000, or 13.2%, to $5.4 million or $2.09 per diluted common share, for the nine months ended September 30, 2020, compared to $4.8 million, or $1.87 per diluted common share, for the nine months ended September 30, 2019. The increases primarily were a result of an increase in noninterest income of $1.0 million and $1.5 million for the three and nine months ended September 30, 2020, respectively.

Interest Income. Interest income decreased $68,000, or 0.8%, to $8.5 million for the three months ended September 30, 2020, from $8.6 million for the three months ended September 30, 2019 and increased $130,000, or 0.5%, to $25.9 million for the nine months ended September 30, 2020. The decrease for the three months ended period was due to lower interest income on

investments, partially offset by higher interest income on higher average loan balances resulting primarily from loans

made by the Bank through its participation in the U.S. Small Business Administration’s (“SBA”) PPP. Interest income on loans increased $227,000, or 2.8%, to $8.4 million for the three months ended September 30, 2020, due to higher average loan balances resulting primarily from PPP loans made by the Bank. The average balance of loans held-for-portfolio was $694.1 million for the three months ended September 30, 2020, compared to $585.8 million for the three months ended September 30, 2019. The average yield on loans held-for-portfolio was 4.82% for three months ended September 30, 2020, compared to 5.54% for the three months ended September 30, 2019. Interest income on the investment portfolio and cash and cash equivalents decreased $295,000, or 77.4%, compared to $381,000 for the three months ended September 30, 2019. The decrease in the interest income on investment securities and cash and cash equivalents compared to the same period a year ago was due to lower average yields. The average yield on investments and cash and cash equivalents was 0.29% for the three months ended September 30, 2020, compared to 2.30% for the three months ended September 30, 2019.

Interest income increased $130,000, or 0.5%, to $25.9 million for the nine months ended September 30, 2020, from $25.7 million for the nine months ended September 30, 2019. The increase was primarily a result of increased interest income on loans due to higher average loan balances, partially offset by a lower interest income on investments. Interest income on loans increased $949,000, or 3.9%, to $25.5 million for the nine months ended September 30, 2020, due to higher average loan balances resulting primarily from PPP loans made by the Bank. The average balance of loans held-for-portfolio was $666.6 million for the nine months ended September 30, 2020, compared to $591.9 million for the nine months ended September 30, 2019. The average yield on loans held-for-portfolio was 5.09% for the nine months ended September 30, 2020, compared to 5.54% for the nine months ended September 30, 2019. Interest income on the investment portfolio and cash and cash equivalents decreased $819,000, or 67.2%, to $400,000 for the nine months ended September 30, 2020, compared to $1.2 million for the nine months ended September 30, 2019. The decrease in the interest income on investment securities and cash and cash equivalents compared to the same period a year ago was due to lower average yields. The average yield on investments including interest-bearing cash was 0.65% for the nine months ended September 30, 2020, compared to 2.57% for the nine months ended September 30, 2019. The average balance of investments, which included interest-bearing cash balances and available-for-sale securities increased $18.2 million, or 28.6%, compared to a year ago.

The average yield on net loans decreased compared to the same period in the prior year due primarily to decreases in interest rates on adjustable rate instruments following decreases to short-term rates over the last year, including the emergency 150 basis point reduction in the targeted federal funds rate in March 2020 due to the COVID-19 pandemic, and secondarily due to the impact of PPP loans. For the nine months ended September 30, 2020, the average balance of PPP loans was $42.5 million and the average yield on PPP loans was 2.64%, including the recognition of the net deferred fees. Interest income included $840,000 in fees earned related to PPP loans in the nine months ended September 30, 2020 compared to none in same period a year ago. The impact of PPP loans on loan yields will change during any period based on the volume of prepayments or amounts forgiven by the SBA as certain criteria are met, but is expected to cease completely after the two or five year maturity of the loans.

Interest Expense. Interest expense decreased $82,000, or 4.2%, to $1.8 million for the three months ended September 30, 2020, from $1.9 million for the three months ended September 30, 2019. Interest expense decreased $13,000, or 0.2%, to $5.6 million for the nine months ended September 30, 2020, from $5.6 million for the nine months ended September 30, 2019. The decrease in interest expense compared to the three and nine month periods a year ago was a result of a higher percentage of noninterest bearing deposits to total deposits and a lower cost of borrowings.

Interest expense on deposits decreased $92,000, or 5.0%, to $1.7 million for the three months ended September 30, 2020, compared to $1.8 million for the same period a year ago. Interest expense on deposits increased $429,000, or 8.7%, to $5.3 million for the nine months ended September 30, 2020, compared to $4.9 million for the same period in 2019. The decrease for

the three month period primarily was due to the lower weighted average interest rate paid on deposits. The increase for the nine month period was primarily due to the increase in average balance of deposits. The average balance of deposits was $715.2 million and $673.0 million during the three and nine months ended September 30, 2020, respectively, compared to $594.4 million and $579.7 million during the three and nine months ended September 30, 2019, respectively. The weighted average rate paid on deposits was 0.96% and 1.06% for the three and nine months ended September 30, 2020, respectively, compared to 1.22% and 1.13% for the three months ended September 30, 2019, respectively. The average rate paid on deposits declined due to a reduction in market interest rates over the last year, primarily as a result of the 150 basis point reduction in the targeted federal funds rate discussed above.

Interest expense on borrowings, including the Notes, increased $10,000, or 10.0%, to $110,000 for the three months ended September 30, 2020 and decreased $442,000, or 65.6%, to $232,000 for the nine months ended September 30, 2020, compared to the comparable periods a year ago. The increase for the three months ended September 30, 2020 was a result of higher weighted-average balance of borrowings, including the Notes, partially offset by a lower weighted average cost of borrowings. The decrease for the nine months ended September 30, 2020 was a result of a lower weighted average balance of borrowings and lower weighted average cost of borrowings. The weighted average balance of borrowings outstanding for the three and nine months ended September 30, 2020 was $42.2 million and $20.8 million, respectively, compared to $8.5 million and $28.8 million for the three and nine months ended September 30, 2019, respectively. On September 18, 2020, the Company completed a private placement of the Notes resulting in net proceeds, after placement fees and offering expenses, of approximately $11.7 million. The weighted average cost of borrowings was 1.04% and 1.49% for the three and nine months ended September 30, 2020, respectively, compared to 4.65% and 3.13% for the three and nine months ended September 30, 2019, respectively.

Net Interest Income. Net interest income increased $14,000, or 0.2%, to $6.7 million for the three months ended September 30, 2020, from $6.6 million for the three months ended September 30, 2019. Net interest income increased $143,000, or 0.7%, to $20.3 million for the nine months ended September 30, 2020, from $20.1 million compared to the same period a year ago. The increase for the three and nine months ended September 30, 2020 primarily was a result of higher interest income on loans and lower interest expense. Our net interest margin was 3.26% and 3.61% for three and nine months ended September 30, 2020, respectively, compared to 4.03% and 4.10% for the three and nine months ended September 30, 2019, respectively. The low interest rate environment putting downward pressure on adjustable rate instruments combined with the impact of the low loan yields of the PPP loan portfolio, and a significant increase in low yielding interest-bearing deposits, adversely impacted net interest margin for the current year. The decreases were also due to yields earned on interest-earning assets declining at a faster rate than interest rates paid on interest-bearing liabilities as changes in the average rate paid on interest-bearing deposits tend to lag changes in market interest rate. The average yield on PPP loans was 2.79% and 2.64% during the three and nine months ended September 30, 2020, including the recognition of the net deferred fees, resulting in a negative impact to the net interest margin.

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

The Company recorded a provision for loan losses of $275,000 and $925,000 for the three and nine months ended September 30, 2020, respectively, compared to a provision for loan losses of $250,000 for the three months ended September 30, 2019 and a recapture from the allowance for loan losses of $150,000 for the nine months ended September 30, 2019, respectively. The increase in the provision primarily reflects current economic conditions and gives consideration of probable loan losses due to the potential effects from higher forecasted unemployment rates and lower gross domestic product, as well as the impact on other economic conditions from COVID-19. Net charge-offs for the three and nine months ended September 30, 2020 were $318,000 and $577,000 respectively, compared to net charge-offs of $2,000 and $6,000 for the three and nine months ended September 30, 2019, respectively.

While we believe the estimates and assumptions used in our determination of the adequacy of the allowance are reasonable, there can be no assurance that such estimates and assumptions will not be proven incorrect in the future, or that the actual amount of future provisions will not exceed the amount of past provisions or that any increased provisions that may be required

will not adversely impact our financial condition and results of operations. A further decline in national and local economic conditions, as a result of the COVID-19 pandemic or other factors, could result in a material increase in the allowance for loan losses and may adversely affect the Company’s financial condition and results of operations. In addition, the determination of the amount of our allowance for loan losses is subject to review by bank regulators as part of the routine examination process, which may result in the adjustment of reserves based upon their judgment of information available to them at the time of their examination.

Noninterest Income. Noninterest income increased $1.0 million, or 93.8%, to $2.1 million for the three months ended September 30, 2020, as compared to $1.1 million for the three months ended September 30, 2019, as reflected below (dollars in thousands):


	Three Months Ended September 30,				Amount Change		Percent Change
	2020		2019
Service charges and fee income	$	510	$	512	$	(2)	(0.4)	%
Earnings on cash surrender value of BOLI	102		81		21		25.9
Mortgage servicing income	260		259		1		0.4
Fair value adjustment on mortgage servicing rights	(623)		(90)		(533)		592.2
Net gain on sale of loans	1,819		305		1,514		496.4

Total noninterest income	$	2,068	$	1,067	$	1,001	93.8	%

The increase in noninterest income during the three months ended September 30, 2020 compared to the same period in 2019 was primarily due to increases in gain on sale of loans, partially offset by an increase in the downward adjustment on the fair value of mortgage servicing rights. Loans sold during the three months ended September 30, 2020, totaled $89.5 million, compared to $16.6 million during the three months ended September 30, 2019, as the volume of loans originated for sale increased significantly due to refinance activity increasing as a result of the recent reductions in market interest rates.

Noninterest income increased $1.5 million, or 51.0%, to $4.4 million for the nine months ended September 30, 2020, as compared to $2.9 million for the nine months ended September 30, 2019, as reflected below (dollars in thousands):


	Nine Months Ended September 30,				Amount Change		Percent Change
	2020		2019
Service charges and fee income	$	1,433	$	1,437	$	(4)	(0.3)	%
Earnings on cash surrender value of BOLI	207		267		(60)		(22.5)
Mortgage servicing income	739		756		(17)		(2.2)
Fair value adjustment on mortgage servicing rights	(1,423)		(576)		(847)		147.0
Net gain on sale of loans	3,399		1,000		2,399		239.9

Total noninterest income	$	4,355	$	2,884	$	1,471	51.0	%

The increase in noninterest income during the nine months ended September 30, 2020 compared to the same period in 2019 was primarily due to increases in gain on sale of loans, partially offset by an increase in the downward adjustment on the fair value of mortgage servicing rights. Loans sold during the nine months ended September 30, 2020, totaled $176.0 million, compared to $54.5 million during the nine months ended September 30, 2019, as the volume of loans originated for sale increased significantly primarily due to refinance activity as a result of low market interest rates.

Noninterest Expense. Noninterest expense increased $10,000, or 0.02%, to $5.5 million during the three months ended September 30, 2020, compared to $5.5 million during the three months ended September 30, 2019, as reflected below (dollars in thousands):


	Three Months Ended September 30,				Amount Change		Percent Change
	2020		2019
Salaries and benefits	$	2,880	$	3,075	$	(195)	(6.3)	%
Operations	1,390		1,397		(7)		(0.5)
Regulatory assessments	111		(49)		160		(326.5)
Occupancy	442		509		(67)		(13.2)
Data processing	707		587		120		20.4
Net loss on OREO and repossessed assets	—		1		(1)		(100.0)
Total noninterest expense	$	5,530	$	5,520	$	10	0.2	%

The slight increase in noninterest expense during the three months ended September 30, 2020 compared to the same period in 2019 was primarily due to increases of $160,000 in regulatory assessments and $120,000 in data processing expense, partially offset by a $195,000 decrease in salaries and benefits expense. Data processing expense increased due to technology investments and variable costs associated with loan origination activity. Salaries and benefits expense decreased primarily due to an increase in deferred loan origination costs related to the PPP loans. Regulatory assessments increased to normal levels as the Bank utilized all of its remaining regulatory assessment credits last year.

Noninterest expense decreased $264,000, or 1.5%, to $16.9 million during the nine months ended September 30, 2020 as compared to $17.1 million during the nine months ended September 30, 2019, as reflected below (dollars in thousands):


	Nine Months Ended September 30,				Amount Change		Percent Change
	2020		2019
Salaries and benefits	$	8,933	$	9,369	$	(436)	(4.7)	%
Operations	4,109		4,481		(372)		(8.3)
Regulatory assessments	480		178		302		169.7
Occupancy	1,437		1,560		(123)		(7.9)
Data processing	1,923		1,547		376		24.3
Net loss on OREO and repossessed assets	—		11		(11)		(100.0)
Total noninterest expense	$	16,882	$	17,146	$	(264)	(1.5)	%

The decrease in noninterest expense during the nine months ended September 30, 2020 compared to the same period in 2019 was primarily due to decreases of $436,000 in salaries and benefits, $372,000 in operations and $123,000 in occupancy expense, partially offset by increases of $376,000 in data processing and $302,000 in regulatory assessments expense. Salaries and benefits expense decreased primarily due to an increase in deferred loan origination costs related to the PPP loans. Operations expense decreased due to decreases in professional and consulting fees, travel and conference and marketing and advertising expense. Data processing expense increased for the same reason set forth above. Regulatory assessments increased to normal levels as the Bank utilized all of its remaining regulatory assessment credits last year and due to costs for the DFI examination paid during the nine months ended September 30, 2020.

The efficiency ratio for the quarter ended September 30, 2020 was 63.36%, compared to 71.57% for the quarter ended September 30, 2019 and was 68.51% for the nine months ended September 30, 2020, compared to 74.46% for the nine months ended September 30, 2019. The improvement in the efficiency ratio primarily was due to higher interest income and noninterest income, and for the nine month period, lower noninterest expense.

Income Tax Expense. We incurred income tax expense of $588,000 and $1.4 million for the three and nine months ended September 30, 2020, respectively, as compared $395,000 and $1.2 million for the same periods in 2019, respectively. The

effective tax rates for the three and nine months ended September 30, 2020 were 20.1% and 20.3%, respectively. The effective tax rates for the three and nine months ended September 30, 2019 were 20.3% and 20.2%, respectively.

Liquidity

The Management Discussion and Analysis in Item 7 of the Company’s 2019 Form 10-K contains an overview of Sound Financial Bancorp’s and the Bank’s liquidity management, sources of liquidity and cash flows. This discussion updates that disclosure for the nine months ended September 30, 2020.

The Bank’s primary sources of funds are deposits, principal and interest payments on loans and borrowings. While maturities and scheduled amortization of loans are a predictable source of funds, deposit flows and loan prepayments are greatly influenced by general interest rates, economic conditions and competition. The Bank’s primary investing activity is loan originations. The Bank maintains liquidity levels it believes to be adequate to fund loan commitments, investment opportunities, deposit withdrawals and other financial commitments. At September 30, 2020, the Bank had $129.1 million in cash and investment securities available-for-sale and $16.1 million in loans held-for-sale generally available for its cash needs. Also, at September 30, 2020, the Bank had the ability to borrow an additional $198.6 million in FHLB advances based on existing collateral pledged, and could access $29.4 million through the Federal Reserve’s Discount Window. Additionally, as of September 30, 2020, the Bank was approved to utilize the PPPLF. The Bank may utilize the PPPLF pursuant to which the Bank will pledge PPP loans at face value as collateral to obtain FRB non-recourse loans. During the quarter ended and as of September 30, 2020, the Bank did not utilize the PPPLF as it held a substantial cash and cash equivalent position as a result of PPP disbursed funds remaining unused in borrower deposit accounts and due to deposit customers increasing their balances due to COVID-19. At September 30, 2020, we also had available a total of $20.0 million in credit facilities with other financial institutions, with no balance outstanding. The Bank uses these sources of funds primarily to meet ongoing commitments, pay maturing deposits and fund withdrawals and loan commitments. At September 30, 2020, outstanding loan commitments, including unused lines and letters of credit totaled $144.6 million, including $27.8 million of undisbursed construction and land loans. Certificates of deposit scheduled to mature in one year or less at September 30, 2020, totaled $186.6 million.

Cash and cash equivalents increased $60.0 million to $115.8 million as of September 30, 2020, from $55.8 million as of December 31, 2019. Net cash used in operating activities was $9.6 million for the nine months ended September 30, 2020. Net cash used in investing activities totaled $73.0 million during the nine months ended September 30, 2020 and consisted primarily of increases in net loans and available-for-sale securities. The $142.6 million of net cash provided by financing activities during the nine months ended September 30, 2020 primarily was the result of a $132.1 million net increase in deposits and the net proceeds received from the issuance and sale of the Notes as discussed above.

As a separate legal entity from the Bank, the Company must provide for its own liquidity. During the quarter ended September 30, 2020, the Company completed a private placement of $12.0 million in aggregate principal amount of the Notes resulting in net proceeds, after placement fees and offering expenses, of approximately $11.7 million. The Company contributed $5.5 million of the net proceeds from the sale of the Notes to the Bank and intends to use the remaining net proceeds from the sale of the notes for general corporate purposes, including stock repurchases and to pay dividends on Company common stock. At September 30, 2020, the Company, on an unconsolidated basis, had $7.6 million in cash, noninterest-bearing deposits and liquid investments generally available for its cash needs. The Company’s principal source of liquidity is dividends and ESOP loan repayments from the Bank.

Except as set forth above, management is not aware of any trends, events, or uncertainties that will have, or that are reasonably likely to have a material impact on liquidity, capital resources or operations.

Off-Balance Sheet Activities

In the normal course of operations, we engage in a variety of financial transactions that are not recorded in our financial statements. These transactions involve varying degrees of off-balance sheet credit, interest rate and liquidity risks. These transactions are used primarily to manage customers’ requests for funding and take the form of loan commitments and lines of credit.

A summary of our off-balance sheet loan commitments at September 30, 2020, is as follows (in thousands):


	September 30, 2020
Commitments to make loans	$	73,484
Unfunded construction commitments	27,790
Unused lines of credit	42,058
Irrevocable letters of credit	1,241
Total loan commitments	$	144,573

Capital

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

Prior to January 1, 2020, Sound Community Bank followed the FDIC’s prompt corrective actions standards. In order to be considered well-capitalized under the prompt corrective action standards, a bank must have a ratio of CET1 capital to risk-weighted assets of at least 6.5%, a ratio of Tier 1 capital to risk-weighted assets of at least 8%, a ratio of total capital to risk-weighted assets of at least 10%, and a leverage ratio of at least 5%, and the bank must not be subject to a regulatory capital requirement imposed on it as an individual bank. In order to be considered adequately capitalized, a bank must have the minimum capital ratios described above. Institutions with lower capital ratios are assigned to lower capital categories. Based on safety and soundness concerns, the FDIC may assign an institution to a lower capital category than would originally apply based on its capital ratios. The FDIC is also authorized to require Sound Community Bank to maintain additional amounts of capital in connection with concentrations of assets, interest rate risk, and certain other items. The FDIC has not imposed such a requirement on Sound Community Bank. Effective January 1, 2020, a bank that elects to use the Community Bank Leverage Ratio (“CBLR”) framework as provided for in the Economic Growth, Regulatory Relief and Consumer Protection Act will generally be considered well-capitalized and to have met the risk-based and leverage capital requirements of the capital regulations if it has a leverage ratio greater than 9.0%. As required by the CARES Act, the FDIC has temporarily lowered the CBLR to 8% beginning in the second quarter of 2020 through the end of the year. Beginning in 2021, the CBLR will increase to 8.5% for that calendar year. The CBLR will return to 9% on January 1, 2022. To be eligible to utilize the CBLR, the Bank also must have total consolidated assets of less than $10 billion, off-balance sheet exposures of 25% or less of its total consolidated assets, and trading assets and trading liabilities of 5.0% or less of its total consolidated assets, all as of the end of the most recent quarter. Beginning January 2020, the Bank elected to use the CBLR framework. At September 30, 2020, the Bank’s CBLR was 10.42%. Management monitors the capital levels to provide for current and future business opportunities and to maintain Sound Community Bank’s “well-capitalized” status. As of September 30, 2020, Sound Community Bank had CBLR in excess of the Federal Reserve’s minimum and well capitalized definitions requirements.

As of December 31, 2019, Sound Community Bank had regulatory capital in excess of the Federal Reserve’s minimum and well capitalized requirement. The actual regulatory capital amounts and ratios calculated for Sound Community Bank at December 31, 2019, were as follows (dollars in thousands):


	Actual				Minimum Capital Requirements				Minimum Required to be Well-Capitalized Under Prompt Corrective Action Provisions
	Amount		Ratio		Amount		Ratio		Amount		Ratio
Tier 1 Capital to average total adjusted assets	$	74,031	10.22	%	$	28,981	4.0	%	$	36,226	5.0	%
Common Equity Tier 1 to risk-weighted assets	74,031		12.07		27,601		4.5		39,868		6.5
Tier 1 Capital to risk-weighted assets	74,031		12.07		36,801		6.0		49,068		8.0
Total Capital to risk-weighted assets	$	79,974	13.04	%	$	49,068	8.0	%	$	61,335	10.0	%

Pursuant to the capital regulations of the FDIC and the other federal banking agencies, the Bank must maintain a capital conservation buffer consisting of additional CET1 capital greater than 2.5% of risk-weighted assets above the required minimum levels of risk-based CET1 capital, tier 1 capital and total capital in order to avoid limitations on paying dividends, repurchasing shares, and paying discretionary bonuses. At December 31, 2019, the Bank’s CET1 capital exceeded the required capital conservation buffer.

For a bank holding company with less than $3.0 billion in assets, the capital guidelines apply on a bank only basis and the Federal Reserve expects the holding company’s subsidiary banks to be well capitalized under the prompt corrective action regulations. If Sound Financial Bancorp was subject to regulatory guidelines for bank holding companies with $3.0 billion or more in assets, at September 30, 2020, Sound Financial Bancorp would have exceeded all regulatory capital requirements. The estimated Community Bank Leverage Ratio calculated for Sound Financial Bancorp as of September 30, 2020 was 10.42%.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

The Company provided information about market risk in Item 7A of its 2019 Form 10-K. There have been no material changes in our market risk since our 2019 Form 10-K.

Item 4. Controls and Procedures

(a)Evaluation of Disclosure Controls and Procedures.

An evaluation of the Company’s disclosure controls and procedures (as defined in Rule 13a -15(e) under the Securities Exchange Act of 1934 (the “Act”)), as of September 30, 2020, was carried out under the supervision and with the participation of the Company’s Chief Executive Officer, Chief Financial Officer, and several other members of the Company’s senior management. The Chief Executive Officer and Chief Financial Officer concluded that, as of September 30, 2020, the Company’s disclosure controls and procedures were effective in ensuring that the information required to be disclosed by the Company in the reports it files or submits under the Act is: (i) accumulated and communicated to the Company’s management (including the Chief Executive Officer and Chief Financial Officer) in a timely manner, and (ii) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

We intend to continually review and evaluate the design and effectiveness of the Company’s disclosure controls and procedures and to improve the Company’s controls and procedures over time and to correct any deficiencies that we may discover in the future. The goal is to ensure that senior management has timely access to all material financial and non-financial information concerning the Company’s business. While we believe the present design of the disclosure controls and procedures is effective to achieve this goal, future events affecting our business may cause the Company to modify its disclosure controls and procedures.

The Company does not expect that its disclosure controls and procedures will prevent all error and all fraud. A control procedure, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control procedure are met. Because of the inherent limitations in all control procedures, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple errors or mistakes. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any control procedure is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies and procedures may deteriorate. Because of the inherent limitations in a cost-effective control procedure, misstatements due to error or fraud may occur and not be detected.

(b)Changes in Internal Control over Financial Reporting.

There were no changes in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Act) that occurred during the three months ended September 30, 2020, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II OTHER INFORMATION

Item 1 Legal Proceedings

In the normal course of business, the Company occasionally becomes involved in various legal proceedings. In the opinion of management, any liability from such proceedings would not have a material adverse effect on the business or financial condition of the Company.

Item 1A Risk Factors

In light of recent developments relating to the COVID-19 pandemic, the Company is supplementing its risk factors contained in Item 1A of its 2019 Form 10-K. The following risk factor should be read in conjunction with the risk factors described in the 2019 Form 10-K.

The COVID-19 pandemic has impacted the way we conduct business which may adversely impact our financial results and those of our customers. The ultimate impact will depend on future developments, which are highly uncertain and cannot be predicted, including the scope and duration of the pandemic and actions taken by governmental authorities in response to the pandemic.

Although the stay-at-home orders in Washington State have been lifted and phased re-opening of businesses has commenced, the majority of our employees with the ability to work remotely have been encouraged to continue doing so, while continuing to provide banking services to our customers. Heightened cybersecurity, information security and operational risks may result from these remote work-from-home arrangements. We also could be adversely affected if key personnel or a significant number of employees were to become unavailable due to the effects and restrictions of the COVID-19 pandemic. We also rely upon our third-party vendors to conduct business and to process, record and monitor transactions. If any of these vendors are unable to continue to provide us with these services, it could negatively impact our ability to serve our customers. Although we have business continuity plans and other safeguards in place, there is no assurance that such plans and safeguards will be effective.

There is pervasive uncertainty surrounding the future economic conditions that will emerge in the months and years following the start of the pandemic. As a result, management is confronted with a significant and unfamiliar degree of uncertainty in estimating the impact of the pandemic on credit quality, revenues and asset values. The COVID-19 pandemic may result in declines in loan demand and loan originations, other than through government sponsored programs such as the Payroll Protection Program, deposit availability, market interest rates and negatively impacted many of our business and consumer borrower’s ability to make their loan payments. Because the length of the pandemic and the efficacy of the extraordinary measures being put in place to address its economic consequences are unknown, including a continued low targeted federal funds rate, until the pandemic subsides, we expect our net interest income and net interest margin will be adversely affected in the near term, if not longer. Many of our borrowers have become unemployed or may face unemployment, and certain businesses are at risk of insolvency as their revenues decline precipitously, especially in businesses related to travel, hospitality, leisure and physical personal services. Businesses may ultimately not reopen as there is a significant level of uncertainty regarding the level of economic activity that will return to our markets over time, the impact of governmental assistance, the speed of economic recovery, the resurgence of COVID-19 in subsequent seasons and changes to demographic and social norms that will take place.

The impact of the pandemic is expected to continue to adversely affect us during 2020 and possibly longer as the ability of many of our customers to make loan payments has been significantly affected. Although the Company makes estimates of loan losses related to the pandemic as part of its evaluation of the allowance for loan losses, such estimates involve significant judgment and are made in the context of significant uncertainty as to the impact the pandemic will have on the credit quality of our loan portfolio. It is likely that increased loan delinquencies, adversely classified loans and loan charge-offs will increase in the future as a result of the pandemic. Consistent with guidance provided by banking regulators, we have modified loans by providing various loan payment deferral options to our borrowers affected by the COVID-19 pandemic. Notwithstanding these modifications, these borrowers may not be able to resume making full payments on their loans once the COVID-19 pandemic is resolved. Any increases in the allowance for credit losses will result in a decrease in net income and, most likely, capital, and may have a material negative effect on our financial condition and results of operations.

Table of Contents

As of September 30, 2020, we held and serviced a portfolio of 909 PPP loans totaling $74.8 million. PPP loans are subject to the provisions of the CARES Act and to complex and evolving rules and guidance issued by the SBA and other government agencies. We expect that the vast majority of our PPP borrowers will seek full or partial forgiveness of their PPP loan obligations. We could face additional risks in our administrative capabilities to service our PPP loans and with respect to the determination of loan forgiveness depending on the final procedures for determining loan forgiveness. Further, since the commencement of the PPP, several larger banks have been subject to litigation regarding their processing of PPP loan applications. The Bank may be exposed to the risk of similar litigation, from both customers and non-customers that approached the Bank seeking PPP loans. PPP lenders, including the Bank, may also be subject to the risk of litigation in connection with other aspects of the PPP, including but not limited to borrowers seeking forgiveness of their loans and PPP agents seeking fees from PPP lenders for assisting borrowers in securing PPP loans. In June 2020, the Bank, along with ten other financial institutions, was sued by an agent on behalf of borrowers in connection with SBA loans under the PPP for fees payable out of the PPP loan processing fees lenders receive from the SBA. If the plaintiff in this litigation or any future litigation filed against the Bank is successful, it may result in significant financial or reputational harm to us. See, “Item 5. Other Information” in Part II of this report for additional information.

Even after the COVID-19 pandemic subsides, the U.S. economy will likely require some time to recover from its effects, the length of which is unknown. and during which we may experience a recession. As a result, we anticipate our business may be materially and adversely affected during this recovery. To the extent the effects of the COVID-19 pandemic adversely impact our business, financial condition, liquidity or results of operations, it may also have the effect of heightening many of the other risks described in the section entitled "Risk Factors" in our 2019 Form 10-K.

Item 2 Unregistered Sales of Equity Securities and use of Proceeds

(a) Not applicable

(b)Not applicable

(c)The Company did not make any stock repurchases during the quarter ended September 30, 2020, and as of that date did not have any publicly announced stock repurchase programs.

Item 3 Defaults Upon Senior Securities

Nothing to report.

Item 4 Mine Safety Disclosures

Not Applicable

Item 5. Other Information

In June 2020, the accounting firm Fruci & Associates, PS (“Plaintiff”) sued Sound Community Bank, along with ten other financial institutions, in United States District Court for the Western District of Washington. Plaintiff alleges that it served as an agent on behalf of borrowers in connection with Small Business Administration (“SBA”) loans under the Paycheck Protection Program (“PPP”), and that the federal CARES Act entitles it to fees, payable out of the PPP loan processing fees lenders receive from the SBA. Plaintiff seeks treble damages on behalf of a putative class of all agents who purportedly are entitled to an agent fee, and seeks unspecified compensatory damages and treble damages. Sound Community Bank believes the complaint lacks merit and moved to dismiss the complaint on July 2, 2020, challenging the Plaintiff’s claimed entitlement to agent fees. The motion has been fully briefed to the court and Sound Community Bank expects a ruling in the near future. At this time, it is not possible to predict the outcome of the lawsuit or the impact on the Bank.

Item 6. Exhibits


Exhibits:
3.1			Articles of Incorporation of Sound Financial Bancorp, Inc. (incorporated herein by reference to the Registration Statement on Form S-1 filed with the SEC on March 27, 2012 (File No. 333-180385))
3.2			Bylaws of Sound Financial Bancorp, Inc. (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on February 3, 2015 (File No. 001-35633))
4.1			Form of Common Stock Certificate of Sound Financial Bancorp, Inc. (incorporated herein by reference to the Registration Statement on Form S-1 filed with the SEC on March 27, 2012 (File No. 333-180385))
4.2			Description of capital stock (incorporated herein by reference to the Annual Report on Form 10-K for the year ended December 31, 2019 (File No. 001-35633))
4.3			Forms of 5.25% Fixed-to-Floating Rate Subordinated Note due October 1, 2030 (included as Exhibit A to the Subordinate Note Purchase Agreement included in Exhibit 10.16) (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on September 21, 2020 (File No. 001-35633)).
10.1			Amended and Restated Employment Agreement dated January 25, 2019, by and between Sound Community Bank and Laura Lee Stewart (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on January 30, 2019 (File No. 001-35633))
10.2			Amended and Restated Supplemental Executive Retirement Agreement by and between Sound Community Bank and Laura Lee Stewart (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on November 27, 2015 (File No. 001-35633))
10.3			Amended and Restated Long Term Compensation Agreement by and between Sound Community Bank and Laura Lee Stewart (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on November 27, 2015 (File No. 001-35633))
10.4			Amended and Restated Confidentiality, Non-Competition and Non-Solicitation Agreement by and between Sound Community Bank and Laura Lee Stewart (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on December 16, 2019 (File No. 001-35633))
10.5			2008 Equity Incentive Plan (incorporated herein by reference to the Annual Report on Form 10-K filed with the SEC on March 31, 2009 (File No. 000-52889))
10.6			Forms of Incentive Stock Option Agreement, Non-Qualified Stock Option Agreement and Restricted Stock Agreements under the 2008 Equity Incentive Plan (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on January 29, 2009 (File No. 000-52889))
10.7			Summary of Annual Bonus Plan (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on February 3, 2020 (File No. 000-35633))
10.8			2013 Equity Inventive Plan (included as Exhibit 10.13 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30,2013 and incorporated herein by reference (File No. 001-35633))
10.9			Form of Incentive Stock Option Agreement, Non-Qualified Stock Option Agreement and Restricted Stock Agreement under the 2013 Equity Incentive Plan (included as Exhibit 10.14 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 2013 and incorporated herein by reference (File No. 001-35633))
10.10			Change of Control Agreement dated June 21, 2016, by and among Sound Financial Bancorp, Inc., Sound Community Bank and Elliott Pierce (incorporated herein by reference to the Quarterly Report on Form 10-Q for the quarter ended March 31, 2017 (File No. 001-35633))
10.11			Adoption Agreement for the Sound Community Bank Nonqualified Deferred Compensation Plan (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on March 24, 2017 (File No. (001-35633))
10.12			The Sound Community Bank Nonqualified Deferred Compensation Plan (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on March 24, 2017 (File No. 001-35633))
10.13			Change of Control Agreement dated October 25, 2018, by and among Sound Financial Bancorp, Inc., Sound Community Bank and Daphne Kelley (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on October 26, 2018 (File No. (001-35633))
10.14			Change of Control Agreement dated October 25, 2018, by and among Sound Financial Bancorp, Inc., Sound Community Bank and Heidi Sexton (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on October 26, 2018 (File No. (001-35633))
10.15			Credit Union of the Pacific Incentive Compensation Achievement Plan, dated January 1, 1994 (incorporated herein by reference to the Annual Report on Form 10-K filed with the SEC on March 14, 2019 (File No. (001-35633))
10.16			Form of Subordinated Note Purchase Agreement, dated September 18, 2020, by and among Sound Financial Bancorp, Inc. and the Purchasers (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on September 21, 2020 (File No. 001-35633)).
31.1			Rule 13(a)-14(a) Certification (Chief Executive Officer)
31.2			Rule 13(a)-14(a) Certification (Chief Financial Officer)
32			Section 1350 Certification
101			The following financial statements from the Sound Financial Bancorp, Inc. Quarterly Report on Form 10-Q for the three months ended September 30, 2020, formatted in Extensive Business Reporting Language (XBRL): (i) condensed consolidated balance sheets, (ii) condensed consolidated statements of income, (iii) condensed consolidated statements of comprehensive income, (iv) condensed consolidated statements of equity (v) condensed consolidated statements of cash flows and (vi) the notes to condensed consolidated financial statements
104			Cover Page Interactive Data File (embedded within the Inline XBRL document)

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


Sound Financial Bancorp, Inc.

Date: November 6, 2020	By:	/s/ Laura Lee Stewart
		Laura Lee Stewart
		President/Chief Executive Officer
		(Principal Executive Officer)


Sound Financial Bancorp, Inc.

Date: November 6, 2020	By:	/s/ Daphne D. Kelley
		Daphne D. Kelley
		Executive Vice President and Chief Financial Officer
		(Principal Financial and Accounting Officer)