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; • 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; • 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, including as a result of the Coronavirus Aid, Relief, and Economic Securities Act of 2020 ("CARES Act") and the Consolidated Appropriations Act, 2021 ("CAA 2021"); • 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; 32 • 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 CARES Act, CAA 2021 and recent COVID 19 vaccination and stimulus efforts, 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, 2020 (“2020 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 June 30, 2021, Sound Financial Bancorp, on a consolidated basis, had assets of $923.2 million, net loans held-for-portfolio of $633.5 million, deposits of $804.7 million and stockholders’ equity of $89.5 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, 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 held in our loan portfolio. 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 2020 Form 10-K. 33 COVID-19 Response The Company continues to offer a variety of relief options designed to support our clients and communities we serve during the ongoing COVID-19 pandemic. 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 first round of the program expired on August 8, 2020, and a second round reopened the program beginning January 1, 2021 through May 31, 2021. During 2021, we continued our participation in the initial SBA PPP by processing applications for PPP loan forgiveness. As of June 30, 2021, we had received SBA forgiveness for 881 PPP loans totaling $71.3 million out of the $76.4 million in PPP loans funded during the first PPP. During the six months ended June 30, 2021, we began accepting and processing loan applications under the second PPP enacted in December 2020. As of June 30, 2021, we had funded 599 PPP loans totaling $42.8 million and had received SBA forgiveness for 224 PPP loans totaling $11.8 million under the second PPP. We had 410 PPP loans outstanding totaling $36.0 million as of June 30, 2021. The following table summarizes our PPP participation as of June 30, 2021 (dollars in thousands): Funded At June 30, 2021 Total Number of Loans Average Loan Amount Outstanding Number of Loans First PPP $ 76,384 916 $ 83,389 $ 5,036 35 Second PPP 42,787 599 71,431 31,007 375 Total PPP loans $ 119,171 1,515 $ 78,661 $ 36,043 410 During the three and six months ended June 30, 2021, we recorded in interest income SBA processing fees of $856 thousand and $1.5 million, respectively, and $240 thousand for both the three and six months ended June 30, 2020. In addition, interest income earned on PPP loans totaled $145 thousand and $276 thousand for the three and six months ended June 30, 2021 and $131 thousand for both the three and six months ended June 30, 2020. Loan Modifications. We are continuing to provide payment relief for both consumer and business clients, most of which relief involves interest only or payment deferrals that range from 90 to 180 days. Deferred loans are re-evaluated at the end of the deferral period and will either return to the original loan terms or be reassessed at that time to determine if a further modification should be granted and if a downgrade in risk rating is appropriate. As of June 30, 2021, we had residential and commercial loans under payment relief related to COVID-19 as summarized below (dollars in thousands): Second Request Third Request Fourth Request Total # of Loans Amount # of Loans Amount # of Loans Amount # of Loans Amount Residential loans (1) 4 $ 175 3 $ 1,011 2 $ 86 9 $ 1,271 Commercial loans (2) 0 — 0 — 3 1,666 3 1,666 Total loans 4 $ 175 3 $ 1,011 5 $ 1,752 12 $ 2,938 (1) Entered into a forbearance agreement with a weighted-average loan-to-value of 72%, 68% and 72% for loans under their second, third or fourth request, respectively. (2) Entered into an interest-only payment agreement with a weighted-average loan-to-value of 65% for loans under their fourth request. The foregoing weighted-average loan-to-values are based on appraisals obtained at the time of loan origination and the current loan amount. All of these loan modifications have been made in response to the COVID-19 pandemic and are not classified as troubled debt restructurings pursuant to applicable accounting and regulatory guidance until the earlier of 60 days after the national emergency termination date or January 1, 2022. 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. 34 Support for Clients, Employees and Community during Pandemic. We remain focused on keeping our employees safe and the Bank running effectively to serve its clients. The Bank is managing branch access and occupancy levels in relation to cases and close contact scenarios, following governmental restrictions and considering public health authority guidelines, and encouraging remote work and supporting employees with paid time off. As of June 30, 2021, all of our branch lobbies were open. The Company is aware of the recent surge in COVID-19 infections arising out of the so-called Delta variant and is prepared to restore other protocols, as may prove to be necessary. 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 June 30, 2021 and December 31, 2020 General. Total assets increased $61.8 million, or 7.2%, to $923.2 million at June 30, 2021 from $861.4 million at December 31, 2020. The increase was primarily a result of a higher balances in cash and cash equivalents and in loans held-for-portfolio. Cash and Securities. Cash and cash equivalents increased $43.0 million, or 22.2%, to $236.8 million at June 30, 2021 from $193.8 million at December 31, 2020 primarily due to deposit growth. Available-for-sale securities, which consist of municipal bonds and agency mortgage-backed securities decreased $2.7 million, or 26.4%, to $7.5 million at June 30, 2021 from $10.2 million at December 31, 2020 as a result of normal pay downs in investment securities during the six months ended June 30, 2021 and the call of a municipal bond for $950 thousand during the second quarter of 2021. Loans. Loans held-for-portfolio, net, increased $26.1 million, or 4.3%, to $633.5 million at June 30, 2021 from $607.4 million at December 31, 2020, driven by our origination of $42.8 million of PPP loans in the second round, a $9.1 million increase in construction and land loans, and the purchase of $24.1 million in jumbo one-to-four family loans during the second quarter of 2021, partially offset by loan repayments, including the forgiveness by the SBA of $11.8 million of commercial business PPP loans during the period. The following table reflects the changes in the loan mix of our loan portfolio at June 30, 2021, as compared to December 31, 2020 (dollars in thousands): June 30, 2021 December 31, 2020 Amount Change Percent Change One-to-four family $ 170,351 $ 130,657 $ 39,694 30.4 % Home equity 15,378 16,265 (887) (5.5) Commercial and multifamily 244,047 265,774 (21,727) (8.2) Construction and land 71,881 62,752 9,129 14.5 Manufactured homes 21,032 20,941 91 0.4 Floating homes 43,741 39,868 3,873 9.7 Other consumer 15,557 15,024 533 3.5 Commercial business 59,969 64,217 (4,248) (6.6) Deferred loan fees (2,323) (2,135) (188) 8.8 Total loans held-for-portfolio, gross 639,633 613,363 26,270 4.3 Allowance for loan losses (6,157) (6,000) (157) 2.6 Total loans held-for-portfolio, net $ 633,476 $ 607,363 $ 26,113 4.3 % The increase in the loan portfolio was primarily related to increases in one-to-four family loans and construction and land loans. One-to-four family loans increased $39.7 million, or 30.4%, to $170.4 million at June 30, 2021, compared to $130.7 million at December 31, 2020, driven primarily by the purchase of $24.1 million in jumbo loans during the second quarter of 2021 and the origination of $24.1 million of conforming and non-conforming jumbo loans in our portfolio. The increase in construction and land for the same period was primarily due to new originations and advances on previously approved loans. These increases were partially offset by decreases in commercial and multifamily loans of $21.7 million and commercial business loans of $4.2 million. The decrease in commercial and multifamily was primarily due to increased payoff activity. The decrease in our commercial business loan portfolio was primarily due to SBA loan forgiveness, partially offset by our origination of 599 PPP loans totaling $42.8 million during the six months ended June 30, 2021. At June 30, 2021, our loan portfolio, net of deferred loan fees, remained well-diversified. Commercial and multifamily real estate loans accounted for 38.0% of total loans, one-to-four family loans, including home equity loans accounted for 28.9% of total loans, commercial business loans accounted for 9.4% of total loans, and consumer loans, consisting of manufactured homes, floating homes, and other consumer loans 35 accounted for 12.5% of total loans at June 30, 2021. Construction and land loans accounted for 11.2% of total loans at June 30, 2021. 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 June 30, Six Months Ended June 30, 2021 2020 2021 2020 Balance at beginning of period $ 5,935 $ 5,893 $ 6,000 $ 5,640 Charge-offs (33) (311) (105) (317) Recoveries 5 49 12 58 Net charge-offs (28) (262) (93) (259) Provision for loan losses during the period 250 400 250 650 Balance at end of period $ 6,157 $ 6,031 $ 6,157 $ 6,031 Ratio of net charge-offs during the period to average loans outstanding during the period (0.02) % (0.15) % (0.03) % (0.08) % June 30, 2021 December 31, 2020 Allowance as a percentage of nonperforming loans (end of period) 412.67 % 208.04 % Allowance as a percentage of total loans (end of period) 0.96 % 0.98 % Our allowance for loan losses increased $157 thousand, or 2.6%, to $6.2 million at June 30, 2021, from $6.0 million at December 31, 2020. Specific loan loss reserves decreased to $337 thousand at June 30, 2021, compared to $378 thousand at December 31, 2020, while general loan loss reserves increased to $5.3 million at June 30, 2021, compared to $5.2 million at December 31, 2020 and the unallocated reserve increased to $488 thousand at June 30, 2021, compared to $406 thousand at December 31, 2020. The increase in the general reserve was primarily a result of the increase in the loan portfolio at June 30, 2021. The $36.0 million balance of PPP loans was omitted from the calculation for the allowance for loan losses at June 30, 2021, as these loans are 100% 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 reduce the Bank’s loan balance for the amount forgiven. Net charge-offs for the three and six months ended June 30, 2021 totaled $28 thousand and $93 thousand, respectively, compared to net charge-offs of $262 thousand and $259 thousand for the three and six months ended June 30, 2020, respectively. At June 30, 2021, the allowance for loan losses as a percentage of total loans and nonperforming loans was 0.96% and 412.67%, respectively, compared to 0.98% and 208.04%, respectively, at December 31, 2020. See “Comparison of Results of Operations for the Three and Six Months Ended June 30, 2021 and 2020 — Provision for Loan Losses.” Mortgage Servicing Rights. The fair value of mortgage servicing rights was $4.2 million at June 30, 2021, an increase of $371 thousand, or 9.8%, from $3.8 million at December 31, 2020. 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. The increase in the fair value was primarily due to an increase in the underlying portfolio, as well as an increase in the market value of the portfolio due to slowing prepayment speeds. Nonperforming Assets. At June 30, 2021, nonperforming assets totaled $2.2 million, or 0.23% of total assets, compared to $3.5 million, or 0.40% of total assets at December 31, 2020. 36 The table below sets forth the amounts and categories of nonperforming assets at the dates indicated (dollars in thousands): Nonperforming Assets June 30, 2021 December 31, 2020 Amount Change Percent Change Nonaccrual loans $ 1,068 $ 2,710 $ (1,642) (60.6) % Nonperforming TDRs 424 174 250 143.7 Total nonperforming loans 1,492 2,884 (1,392) (48.3) OREO and repossessed assets 659 594 65 10.9 Total nonperforming assets $ 2,151 $ 3,478 $ (1,327) (38.2) % Nonperforming loans decreased $1.4 million, or 48.3%, to $1.5 million at June 30, 2021 from $2.9 million at December 31, 2020. The percentage of nonperforming loans to total loans was 0.23% at June 30, 2021, compared to 0.47% of total loans at December 31, 2020. Deposits. Total deposits increased $56.7 million, or 7.6%, to $804.7 million at June 30, 2021 from $748.0 million at December 31, 2020. The increase was due primarily to disbursements of PPP loan proceeds into borrowers’ deposit accounts as well as stimulus funds deposited, and 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 $49.4 million, or 37.3%, to $181.8 million at June 30, 2021, compared to $132.5 million at December 31, 2020. Noninterest-bearing deposits represented 22.6% of total deposits at June 30, 2021, compared to 17.7% at December 31, 2020. A summary of deposit accounts with the corresponding weighted-average cost of funds at the dates indicated is presented below (dollars in thousands): June 30, 2021 December 31, 2020 Amount Wtd. Avg. Rate Amount Wtd. Avg. Rate Noninterest-bearing demand $ 178,824 — % $ 129,299 — % Interest-bearing demand 297,227 0.20 230,492 0.44 Savings 97,858 0.10 83,778 0.27 Money market 72,553 0.23 65,748 0.39 Time deposits 155,235 1.81 235,473 2.43 Escrow (1) 3,023 — 3,191 — Total deposits $ 804,720 0.56 % $ 747,981 1.11 % (1) Escrow balances shown in noninterest-bearing deposits on the consolidated balance sheets. Stockholders’ Equity. Total stockholders’ equity increased $4.1 million, or 4.7%, to $89.5 million at June 30, 2021, from $85.5 million at December 31, 2020. This increase primarily reflects $4.7 million in net income for the six months ended June 30, 2021, partially offset by the payment of cash dividends of $1.1 million to common stockholders during the six months ended June 30, 2021. 37 Average Balances, Net Interest Income, Yields Earned and Rates Paid The following table presents, for the periods indicated, the total dollar amount of interest income from average interest-earning assets and the resultant yields, as well as the interest expense on average interest-bearing liabilities, expressed both in dollars and rates. Income and yields on tax-exempt obligations have not been computed on a tax equivalent basis. All average balances are daily average balances. Nonaccrual loans have been included in the table as loans carrying a zero yield for the period they have been on nonaccrual (dollars in thousands). Three Months Ended June 30, 2021 2020 Average Outstanding Balance Interest Earned/ Paid Yield/ Rate Annualized Average Outstanding Balance Interest Earned/ Paid Yield/ Rate Annualized Interest-earning assets: Loans receivable $ 628,144 $ 8,299 5.30 % $ 683,140 $ 8,631 5.08 % Investments and interest-bearing accounts 249,863 116 0.19 67,994 77 0.46 Total interest-earning assets (1) 878,007 8,415 3.84 751,134 8,708 4.66 Interest-bearing liabilities: Savings and money market accounts 166,484 38 0.09 124,664 73 0.24 Demand and NOW accounts 284,952 159 0.22 175,204 215 0.49 Certificate accounts 174,727 699 1.60 247,212 1,461 2.38 Subordinated notes 11,606 168 5.81 — — — Borrowings — — — 12,196 63 2.08 Total interest-bearing liabilities 637,769 1,064 0.67 % 559,276 1,812 1.30 % Net interest income $ 7,351 $ 6,896 Net interest rate spread 3.18 % 3.36 % Net earning assets $ 240,238 $ 191,858 Net interest margin 3.36 % 3.69 % Average interest-earning assets to average interest-bearing liabilities 137.67 % 134.30 % (1) Calculated net of deferred loan fees, loan discounts and loans in process. 38 Six Months Ended June 30, 2021 2020 Average Outstanding Balance Interest Earned/ Paid Yield/ Rate Annualized Average Outstanding Balance Interest Earned/ Paid Yield/ Rate Annualized Interest-earning assets: Loans receivable $ 628,270 $ 16,184 5.19 % $ 652,222 $ 17,040 5.24 % Investments and interest-bearing accounts 239,733 229 0.19 64,800 314 0.97 Total interest-earning assets (1) 868,003 16,413 3.81 % 717,022 17,354 4.85 Interest-bearing liabilities: Savings and money market accounts 161,198 102 0.13 117,629 166 0.28 Demand and NOW accounts 267,019 344 0.26 168,446 446 0.53 Certificate accounts 194,512 1,744 1.81 247,101 2,995 2.43 Subordinated notes 11,601 336 5.84 — — — Borrowings — — — 9,991 123 2.47 Total interest-bearing liabilities 634,330 2,526 0.80 % 543,167 3,730 1.38 % Net interest income $ 13,887 $ 13,624 Net interest rate spread 3.01 % 3.48 % Net earning assets $ 233,673 $ 173,855 Net interest margin 3.23 % 3.81 % Average interest-earning assets to average interest-bearing liabilities 136.84 % 132.01 % (1) Calculated net of deferred loan fees, loan discounts and loans in process. Rate/Volume Analysis The following schedule presents the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. It distinguishes between changes related to outstanding balances and changes due to interest rates. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (i.e., changes in volume multiplied by old rate) and (ii) changes in rate (i.e., changes in rate multiplied by old volume). For purposes of this table, changes attributable to both rate and volume, which cannot be segregated, have been allocated proportionately to the change due to volume and the change due to rate (dollars in thousands). Three Months Ended June 30, 2021 vs. 2020 Six Months Ended June 30, 2021 vs. 2020 Increase (Decrease) due to Total Increase (Decrease) Increase (Decrease) due to Total Increase (Decrease) Volume Rate Volume Rate Interest-earning assets: Loans $ (727) $ 395 $ (332) $ (617) $ (239) $ (856) Investments and interest-bearing accounts 84 (45) 39 167 (252) (85) Total interest-earning assets (643) 350 (293) (450) (491) (941) Interest-bearing liabilities: Savings and Money Market accounts 10 (45) (35) 28 (92) (64) Demand and NOW accounts 61 (117) (56) 127 (229) (102) Certificate accounts (290) (472) (762) (472) (779) (1,251) Subordinated debt 168 — 168 336 — 336 Borrowings — (63) (63) — (123) (123) Total interest-bearing liabilities $ (51) $ (697) $ (748) $ 19 $ (1,223) $ (1,204) Change in net interest income $ 455 $ 263 39 Comparison of Results of Operation for the Three and Six Months Ended June 30, 2021 and 2020 General. Q2 2021 vs Q2 2020 . Net income increased $123 thousand, or 5.8%, to $2.3 million, or $0.85 per diluted common share, for the three months ended June 30, 2021, compared to $2.1 million, or $0.82 per diluted common share, for the three months ended June 30, 2020. The increase in net income was primarily the result of lower interest expense paid on deposits and an increase in noninterest income, partially offset by lower interest income earned on loans, higher interest expense paid on borrowings, and an increase in noninterest expense. YTD 2021 vs. YTD 2020 . Net income increased $1.6 million, or 51.3%, to $4.7 million, or $1.78 per diluted common share, for the six months ended June 30, 2021, compared to $3.1 million, or $1.20 per diluted common share, for the six months ended June 30, 2020. The increase was primarily a result of an increase in noninterest income of $2.1 million for the six months ended June 30, 2021, driven by an increase of $1.5 million in gains on sale of loans, partially offset by an increase in noninterest expense. Interest Income Q2 2021 vs Q2 2020 . Interest income decreased $293 thousand, or 3.4%, to $8.4 million for the three months ended June 30, 2021, from $8.7 million for the three months ended June 30, 2020, primarily due to lower average loan balances, partially offset by a 22 basis point increase in average loan yields. Interest income on loans decreased $332 thousand, or 3.8%, to $8.3 million for the three months ended June 30, 2021, compared to $8.6 million for the three months ended June 30, 2020, driven by lower average total loan balances resulting primarily from the decline in commercial and multifamily loans and commercial business loans. The average balance of total loans was $628.1 million for the three months ended June 30, 2021, compared to $683.1 million for the three months ended June 30, 2020. The average yield on total loans was 5.30% for three months ended June 30, 2021, compared to 5.08% for the three months ended June 30, 2020. The average yield on loans increased primarily due to the recognition of net deferred fees from SBA’s forgiveness of PPP loans during the period. For the three months ended June 30, 2021, the average balance of PPP loans was $60.0 million and the average yield on PPP loans was 6.68%, including the recognition of the net deferred fees, with a positive impact on loan yield of 15 basis points. For the three months ended June 30, 2020, the average balance of PPP loans was $52.7 million and the average yield on PPP loans was 2.84%, including the recognition of deferred fees, with a negative impact on loan yield of 19 basis points. Interest income included $1.0 million in fees earned related to PPP loans in the three months ended June 30, 2021, compared to $372 thousand in the same period a year ago. At June 30, 2021, PPP deferred loan origination fees of $1.3 million remain to be accreted into interest income during the remaining life of the loans. 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 income on the investment portfolio and cash and cash equivalents increased $39 thousand, or 50.6%, to $116 thousand for the three months ended June 30, 2021, compared to $77 thousand for the three months ended June 30, 2020. The increase in the interest income on investment securities and cash and cash equivalents was due to significantly higher average balances, partially offset by lower average yields. The average balance on investments and cash and cash equivalents was $249.9 million for the three months ended June 30, 2021, compared to $68.0 million for the three months ended June 30, 2020. The substantial increase was due to higher average cash balances primarily due to the increase in deposit balances related to SBA PPP loans originrated in the past year. This excess liquidity negatively impacted the average yield on investments and cash and cash equivalents, which decreased to 0.19% for the three months ended June 30, 2021, compared to 0.46% for the three months ended June 30, 2020. YTD 2021 vs. YTD 2020 . Interest income decreased $941 thousand, or 5.4%, to $16.4 million for the six months ended June 30, 2021, from $17.4 million for the six months ended June 30, 2020. The decrease was primarily due to a 104 basis point decline in average yield on interest-earning assets. Interest income on loans decreased $856 thousand, or 5.0%, to $16.2 million for the six months ended June 30, 2021, compared to $17.0 million for the six months ended June 30, 2020, driven by lower average total loans resulting primarily from the decline in commercial and multifamily loans and commercial business loans and a five basis points decline in the average yield on loans. The average balance of total loans was $628.3 million for the six months ended June 30, 2020, compared to $652.2 million for the six months ended June 30, 2020. The average yield on total loans was 5.19% for the six months ended June 30, 2021, compared to 5.24% for the six months ended June 30, 2020. The decline in the average yield on loans was muted by SBA’s forgiveness of PPP loans during the period. For the six months ended June 30, 2021, the average balance of PPP loans was $57.0 million and the average yield on PPP loans was 6.21%, including the recognition of the net deferred fees, with a positive impact on average loan yield of 10 basis points. For the six months ended June 30, 2020, the average balance of PPP loans was $26.3 million and the average yield on PPP loans was 2.83%, 40 including the recognition of deferred fees, with a negative impact on average loan yield of 10 basis points. Interest income included $1.8 million in fees earned related to PPP loans in the six months ended June 30, 2021, compared to $372 thousand in the same period a year ago. Interest income on the investment portfolio and cash and cash equivalents decreased $85 thousand, or 27.1%, to $229 thousand for the six months ended June 30, 2021, compared to $314 thousand for the six months ended June 30, 2020. The decrease in the interest income on investment securities and cash and cash equivalents was due to lower average yields, partially offset by higher average balances. The average yield on investments and cash and cash equivalents was 0.19% for the six months ended June 30, 2021, compared to 0.97% for the six months ended June 30, 2020, primarily due to the substantial increase in cash and cash equivalents earning a nominal yield. Interest Expense Q2 2021 vs Q2 2020 . Interest expense decreased $748 thousand, or 41.3%, to $1.1 million for the three months ended June 30, 2021, from $1.8 million for the three months ended June 30, 2020, primarily as a result of declining deposit costs, a higher percentage of noninterest bearing deposits to total deposits and repayment of FHLB advances, partially offset by the interest expense on subordinated notes issued in the third quarter of 2020. Interest expense on deposits decreased $853 thousand, or 48.8%, to $896 thousand for the three months ended June 30, 2021, compared to $1.7 million for the same period a year ago. The decrease was primarily the result of a decline in the weighted-average cost of deposits reflecting reduced rates paid on deposits. In addition, deposit costs were favorably impacted by a $44.2 million increase in average noninterest bearing deposits to $179.6 million for the three months ended June 30, 2021, compared to $135.4 million for the same period last year. The weighted-average cost of total deposits decreased 58 basis points to 0.45% for the quarter ended June 30, 2021, from 1.03% for the quarter ended June 30, 2020. Interest expense on borrowings increased $105 thousand, or 166.7%, to $168 thousand for the three months ended June 30, 2021, comprised solely of interest expense on our subordinated notes, compared to $63 thousand for the three months ended June 30, 2020, comprised solely of interest expense on our FHLB advances. Average borrowings decreased $590 thousand, to $11.6 million at June 30, 2021, consisting solely of subordinated notes, from $12.2 million at June 30, 2020, which consisted solely of FHLB advances. The weighted-average cost of the subordinated notes was 5.81% for the three months ended June 30, 2021, while the weighted-average cost of the FHLB advances was 2.08% for the three months ended June 30, 2020. YTD 2021 vs. YTD 2020 . Interest expense decreased $1.2 million, or 32.3%, to $2.5 million for the six months ended June 30, 2021, from $3.7 million for the six months ended June 30, 2020, primarily as a result of declining deposit costs and a higher percentage of noninterest bearing deposits to total deposits. Interest expense on deposits decreased $1.4 million, or 39.3%, to $2.2 million for the six months ended June 30, 2021, compared to $3.6 million for the same period a year ago. The decrease was primarily the result of a decline in the average cost of deposits reflecting reduced market rates paid on deposits. The average cost of total deposits decreased 55 basis points to 0.56% for the six months ended June 30, 2021, from 1.11% for the six months ended June 30, 2020. Interest expense on borrowings increased $213 thousand, or 173.2%, to $336 thousand for the six months ended June 30, 2021, comprised solely of interest expense on our subordinated notes, compared to $123 thousand for the six months ended June 30, 2020, which was related solely to FHLB advances. Average borrowings increased $1.6 million, to $11.6 million at June 30, 2021, consisting solely of subordinated notes, from $10.0 million at June 30, 2020, which consisted of solely FHLB advances. The average cost of the subordinated notes was 5.84% for the six months ended June 30, 2021, while the average cost of the FHLB advances was 2.47% for the six months ended June 30, 2020. Net Interest Income. Q2 2021 vs Q2 2020 . Net interest income increased $455 thousand, or 6.6%, to $7.4 million for the three months ended June 30, 2021, from $6.9 million for the three months ended June 30, 2020. Our net interest margin was 3.36% and 3.69% for the three months ended June 30, 2021 and 2020, respectively. The increase in net interest income primarily resulted from the decline in the average rate paid on deposits. The decrease in net interest margin was primarily 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. During the second quarter of 2021, the average yield earned on PPP loans, including the recognition of the net deferred fees for PPP loans repaid and forgiven by the SBA, resulted in a positive impact to the net interest margin of 24 basis points, compared to a negative impact of 6 basis points during the quarter ended June 30, 2020. 41 YTD 2021 vs. YTD 2020 . Net interest income increased $263 thousand, or 1.9%, to $13.9 million for the six months ended June 30, 2021, from $13.6 million for the six months ended June 30, 2020. Our net interest margin was 3.23% and 3.81% for the six months ended June 30, 2021, respectively. The increase in net interest income primarily resulted from the decline in the average rate paid on deposits being substantially offset by declines in both the average loan balance and yield. The decrease in net interest margin was primarily 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. Provision 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. A provision for loan losses of $250 thousand was recorded for both of the three and six months ended June 30, 2021, as compared to $400 thousand and $650 thousand for the three and six months ended June 30, 2020, respectively. The decrease in the provision for loan losses in the current quarter and six-month period compared to the comparable periods in 2020 was primarily due to a decrease in the balance of loans held-for-portfolio and in the current quarter, a $2.0 million decrease in non-performing loans from June 30, 2020. Our allowance for loan losses as of June 30, 2021, not only reflects probable and inherent credit losses based upon the economic conditions that existed as of June 30, 2021, but also reflects the inherent economic improvements in our markets as initial COVID-19 restrictions implemented in the second quarter of last year have been lifted. Net charge-offs for the three and six months ended June 30, 2021 totaled $28 thousand and $93 thousand, respectively, compared to net charge-offs of $262 thousand and $259 thousand for the three and six months ended June 30, 2020, 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. Recently, we have seen most of our market areas reporting a fairly significant increase in COVID transmissions, which we understand from our public health authorities is largely attributed to lagging vaccination rates and an increase in cases related to the Delta variant. To date, we are not seeing renewed business activity restrictions in our primary markets. To the extent business activity restrictions are renewed, due to COVID-19 or otherwise, this will likely affect our business operations which may, in turn, result in a material increase our provision for loan and lease losses which would 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. 42 Noninterest Income. Noninterest income increased $133 thousand, or 8.4%, to $1.7 million for the three months ended June 30, 2021, as compared to $1.6 million for the three months ended June 30, 2020, as reflected below (dollars in thousands): Three Months Ended June 30, Amount Change Percent Change 2021 2020 Service charges and fee income $ 526 $ 429 $ 97 22.6 % Earnings on cash surrender value of BOLI 96 90 6 6.7 Mortgage servicing income 321 235 86 36.6 Fair value adjustment on mortgage servicing rights (294) (437) 143 (32.7) Net gain on sale of loans 1,063 1,262 (199) (15.8) Total noninterest income $ 1,712 $ 1,579 $ 133 8.4 % The increase in noninterest income during the three months ended June 30, 2021 compared to the same period in 2020 was primarily due to $143 thousand improvement in the fair value adjustment on mortgage servicing rights and increases in both our mortgage servicing income of $86 thousand and service charges and fee income of $97 thousand, partially offset by the decrease in our net gain on sale of loans. The improvement in the fair value adjustment on mortgage servicing rights resulted from loan prepayment speeds slowing during the quarter as mortgage interest rates moved slightly higher during the quarter. The increase in the service charges and fee income primarily resulted from an increase in the number of checking accounts and an increase in debit card interchange fees. These increases were partially offset by the decrease in the net gain on sale of loans. As a result of refinance activity slowing over the past quarter, our residential loans originated for sale decreased. Loans sold during the quarter ended June 30, 2021, totaled $39.9 million, compared to $57.3 million during the quarter ended June 30, 2020. Noninterest income increased $2.1 million, or 93.1%, to $4.4 million for the six months ended June 30, 2021, as compared to $2.3 million for the six months ended June 30, 2020, as reflected below (dollars in thousands): Six Months Ended June 30, Amount Change Percent Change 2021 2020 Service charges and fee income $ 1,059 $ 923 $ 136 14.7 % Earnings on cash surrender value of BOLI 178 105 73 69.5 Mortgage servicing income 633 479 154 32.2 Fair value adjustment on mortgage servicing rights (569) (800) 231 (28.9) Net gain on sale of loans 3,116 1,581 1,535 97.1 Total noninterest income $ 4,417 $ 2,288 $ 2,129 93.1 % The increase in noninterest income during the six months ended June 30, 2021, compared to the same period in 2020 was primarily due to an increase in gain on sale of loans. As a result of reductions in market interest rates, refinance and home purchases have increased significantly over the last year, increasing our residential loans originated for sale. Loans sold during the six months ended June 30, 2021, totaled $108.0 million, compared to $80.6 million during the six months ended June 30, 2020. 43 Noninterest Expense. Noninterest expense increased $582 thousand, or 10.8%, to $6.0 million during the three months ended June 30, 2021, compared to $5.4 million during the three months ended June 30, 2020, as reflected below (dollars in thousands): Three Months Ended June 30, Amount Change Percent Change 2021 2020 Salaries and benefits $ 3,314 $ 2,818 $ 496 17.6 % Operations 1,361 1,326 35 2.6 Regulatory assessments 91 120 (29) (24.2) Occupancy 409 497 (88) (17.7) Data processing 813 645 168 26.0 Total noninterest expense $ 5,988 $ 5,406 $ 582 10.8 % The increase in noninterest expense during the three months ended June 30, 2021 compared to the same period in 2020 was due to an increase in salaries and benefits of $496 thousand primarily due to higher deferred compensation during 2020 and an increase in data processing expense of $168 thousand due to technology investments and variable costs associated with increased loan originations. These increases were partially offset by a decrease of $88 thousand in occupancy expense. Noninterest expense increased $799 thousand, or 7.0%, to $12.2 million during the six months ended June 30, 2021, compared to $11.4 million during the six months ended June 30, 2020, as reflected below (dollars in thousands): Six Months Ended June 30, Amount Change Percent Change 2021 2020 Salaries and benefits $ 6,958 $ 6,053 $ 905 15.0 % Operations 2,567 2,720 (153) (5.6) Regulatory assessments 192 369 (177) (48.0) Occupancy 857 995 (138) (13.9) Data processing 1,593 1,215 378 31.1 Net gain on OREO and repossessed assets (16) — (16) (100.0) Total noninterest expense $ 12,151 $ 11,352 $ 799 7.0 % The increase in noninterest expense during the six months ended June 30, 2021 compared to the same period in 2020 was primarily due to increases of $905 thousand in salaries and benefits and $378 thousand in data processing expense, partially offset by a $153 thousand decrease in operations expense, a $177 thousand decrease in regulatory assessments and a $138 thousand decrease in occupancy expense. Salaries and benefits increased primarily due to discretionary bonuses paid for added efforts associated with the Company's COVID-19 response, implementation and execution of the SBA's PPP and higher medical expenses during 2021 as compared to 2020. Data processing expense increased due to technology investments and variable costs associated with increased loan originations. Operations expense decreased primarily due to lower loan expenses and office operations, and regulatory assessments decreased as the six months ended June 30, 2020 included regulatory examination costs. Occupancy expense decreased due to the closure of one branch location in June 2020. The efficiency ratio for the quarter ended June 30, 2021 was 66.07%, compared to 63.79% for the quarter ended June 30, 2020, and was 66.38% for the six months ended June 30, 2021, compared to 71.34% for the six months ended June 30, 2020. The weakening in the efficiency ratio for the current quarter compared to the same period in the prior year is primarily due to higher noninterest expense, partially offset by higher interest income and noninterest income. The improvement in the efficiency ratio was primarily due to higher noninterest income for the six months ended June 30, 2021. Income Tax Expense . We incurred income tax expense of $574 thousand and $1.2 million for the three and six months ended June 30, 2021, respectively, as compared $541 thousand and $802 thousand for the same periods in 2020. The effective tax rates for the three and six months ended June 30, 2021 were 20.32% and 20.35%, respectively. The effective tax rates for the three and six months ended June 30, 2020 were 20.27% and 20.51%, respectively. 44 Liquidity and Capital Resources The Management Discussion and Analysis in Item 7 of the Company’s 2020 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 six months ended June 30, 2021. 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 June 30, 2021, the Bank had $244.3 million in cash and investment securities available-for-sale and $3.7 million in loans held-for-sale generally available for its cash needs. Also, at June 30, 2021, the Bank had the ability to borrow an additional $131.9 million in FHLB advances based on existing collateral pledged, and could access $24.8 million through the Federal Reserve’s Discount Window. Additionally, as of June 30, 2021, 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 June 30, 2021, 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. The termination date for the PPPLF is July 30, 2021; as a result, no new extensions of credit will be made under the PPPLF after that date. At June 30, 2021, 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 June 30, 2021, outstanding loan commitments totaled $85.7 million, including unused lines and letters of credit of $25.3 million and undisbursed construction and land loans of $38.2 million. Certificates of deposit scheduled to mature in one year or less at June 30, 2021, totaled $93.1 million. Cash and cash equivalents increased $43.0 million to $236.8 million as of June 30, 2021, from $193.8 million as of December 31, 2020. Net cash provided by operating activities was $14.3 million for the six months ended June 30, 2021. Net cash used in investing activities totaled $27.0 million during the six months ended June 30, 2021 and consisted primarily of increases in loans and the purchase of BOLI, partially offset by principal payments on maturities of investment securities. The $55.7 million of net cash provided by financing activities during the six months ended June 30, 2021 primarily was the result of a $56.7 million net increase in deposits. At June 30, 2021, the Company, on an unconsolidated basis, had $5.4 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. The long-term ability of the Company to pay dividends to its stockholders is based primarily upon the ability of the Bank to make capital distributions to the Company. So long as the Bank remains well capitalized after each capital distribution (as evidenced by maintaining a Community Bank Leverage Ratio ("CBLR") greater than the required percentage), as discussed below, and operates in a safe and sound manner, it is management's belief that its banking regulators will continue to allow the Bank to distribute its earnings to the Company, although no assurance can be given in this regard. 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 June 30, 2021, is as follows (in thousands): June 30, 2021 Commitments to make loans $ 22,065 Unfunded construction commitments 38,225 Unused lines of credit 25,308 Irrevocable letters of credit 80 Total loan commitments $ 85,678 Regulatory Capital Consistent with our goal to operate a sound and profitable financial organization, we actively seek to maintain a well-capitalized status for the Bank per the regulatory framework for prompt corrective action (“PCA”). Qualifying institutions that 45 elect to use the CBLR framework, such as the Bank and the Company, that maintain the required minimum leverage ratio will be considered to have satisfied the generally applicable risk-based and leverage capital requirements in the regulatory agencies' capital rules, and to have met the capital requirements for the well capitalized category under the agencies’ PCA framework. As of June 30, 2021, the Bank and Company’s CBLR was 10.28% and 9.57%, respectively, which exceeded the minimum requirements. See "Part I, Item 1. Business – Regulation of Sound Community Bank – Capital Rules " in the Company's 2020 Form 10-K for additional information related to regulatory capital. Item 3. Quantitative and Qualitative Disclosures About Market Risk The Company provided information about market risk in Item 7A of its 2020 Form 10-K. There have been no material changes in our market risk since our 2020 Form 10-K.