Sound Financial Bancorp, Inc. 10-Q

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; 37 • 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 38 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. 39 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. 40 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. 41 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. 42 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) % 43 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. 44 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 45 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 Losse s. 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 46 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. 47 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 48 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): 49 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. 50 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.