Sound Financial Bancorp Inc
Annual Report 2018

Plain-text annual report

FINANCIAL BANCORP, INC. the rewards of ease access transparency 2018 Annual Report  (cid:36)(cid:3)(cid:48)(cid:40)(cid:54)(cid:54)(cid:36)(cid:42)(cid:40)(cid:3)(cid:41)(cid:53)(cid:50)(cid:48)(cid:3)(cid:55)(cid:43)(cid:40)(cid:3)(cid:51)(cid:53)(cid:40)(cid:54)(cid:44)(cid:39)(cid:40)(cid:49)(cid:55)(cid:3)(cid:9)(cid:3)(cid:38)(cid:40)(cid:50) Dear Shareholder, With great appreciation, we thank you for your investment in our company and announce the results of another exceptional year. We achieved new milestones in balance sheet growth and earnings. We welcomed new consumer, business, and not-for-profit clients which are highlighted in our enclosed Sustainability Report. Our strong regional economy allowed us to generate robust loan originations which funded our balance sheet growth. Credit quality remained solid in 2018. Tax reform fueled higher revenue in 2018 with an improved Return on Average Assets and Return on Average Equity, 1.03% and 10.24% respectively, compared to 0.87% and 8.13% respectively for the year ended 2017. Our energy was simultaneously directed toward supporting and sustaining our communities through the gifts of time and philanthropic donations. During the year we earned an impressive number accolades: #2 Top Corporate Philanthropist in the Small Business category (Puget Sound Business Journal), a Top 200 Performing Community Bank in the Nation (American Banker), on the list of Largest Banks Headquartered in Washington State (Puget Sound Business Journal), and one of the Fastest Growing Publicly Traded Companies in Washington State (Puget Sound Business Journal). In addition, I was recognized as Community Banker of the Year by American Banker. We are humbled and honored by these remarkable recognitions. Again, thank you for your support. We look forward to another outstanding year! Most sincerely, Laura Lee (Laurie) Stewart Board of Directors – left to right: Robert F. Carney, Debra L. Jones, Tyler K. Myers (Chairman), James E. Sweeney, Laura Lee Stewart (President & CEO), David S. Haddad Jr. (Vice Chairman), Rogelio Riojas, Kathleen B. Cook Celebrating more than 10 years as a publicly traded company, Nasdaq invited SFBC to ring the closing market bell on February 6, 2019. Executives also participated in a live interview on Nasdaq’s streaming channel Behind the Bell. Family members joined bank executives and employees on stage to witness President & CEO Laurie Stewart mark the end of stock trading for the day. Photo Credit: Nasdaq About the Cover: Adorning the skyline of Seattle is the iconic Space Needle. The futuristic Space Needle opened for the Seattle 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Corporate Information Sound Financial Bancorp, Inc. is a bank holding company, regulated by the Board of Governors of the Federal Reserve System. Our principal business is operating our wholly-owned subsidiary, Sound Community Bank. Sound Financial Bancorp, Inc.’s executive offices are located at 2400 3rd Avenue, Suite 150, Seattle, Washington 98121 and the telephone number is (206) 448-0884. Sound Community Bank is a Washington State chartered commercial bank with eight full-service banking offices and two loan production offices in the greater Puget Sound area of Washington State. It is a community focused institution, primarily engaging in attracting deposits from the general public and originating loans to individuals and businesses. Board of Directors of Sound Financial Bancorp, Inc. and Sound Community Bank Tyler K. Myers, Chairman President, General Partner, The Myers Group David S. Haddad, Jr. Vice Chairman, Retired Laura Lee Stewart President/Chief Executive Officer, Sound Financial Bancorp, Inc. & Sound Community Bank Robert F. Carney Director of Meat and Seafood Merchandising, Scolaris Food & Drug Company Debra Jones, CPA Retired Vice President of Administrative Services, Bellingham Technical College Rogelio Riojas Chief Executive Officer, Sea Mar Community Health Centers James E. Sweeney Retired Vice President, Vitamin Shoppe, Inc. Kathleen B. Cook Retired Vice President of Regulatory Compliance, FannieMae Executive Officers of Sound Financial Bancorp, Inc. and Sound Community Bank Laura Lee Stewart President/Chief Executive Officer Sound Financial Bancorp, Inc. & Sound Community Bank Elliott Pierce Executive Vice President, Chief Credit Officer Sound Community Bank Christina Gehrke Executive Vice President, Chief Administrative Officer Sound Community Bank Heidi Sexton Executive Vice President, Chief Operating Officer, Sound Community Bank Daphne Kelley Executive Vice President, Chief Financial Officer, Sound Financial Bancorp, Inc. & Sound Community Bank Sound Financial Bancorp, Inc. Shareholder Information Annual Meeting The Annual Meeting of Shareholders of Sound Financial Bancorp, Inc. will be held on May 28, 2019, 10:30 AM, 2400 3rd Avenue, Suite 150, Seattle, WA 98121. Stock Listing; Price Range of Common Stock and Dividends Sound Financial Bancorp, Inc. common stock is traded on the NASDAQ Capital Market under the symbol “SFBC”. The stock price information set forth in the table was provided by the Yahoo Finance System and is based on NASDAQ quotations. The closing price of our common stock on March 29, 2019 was $33.95 The Board of Directors and management of Sound Financial Bancorp, Inc. continually review our ability to pay cash dividends on common stock. Sound Financial Bancorp, Inc. paid dividends totaling 54 cents a share during 2018. 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Annual Report on Form 10-K Our Annual Report on Form 10-K for the year ended December 31, 2018 is included in this Annual Report of Shareholders. Additional copies of the Company's Form 10-K, as filed with the Securities and Exchange Commission, may be obtained without charge by contacting Daphne Kelley EVP/CFO at Sound Financial Bancorp, Inc., 2400 3rd Avenue, Suite 150, Seattle, Washington, 98121. This information is also available at soundcb.com under Investor Relations. Stockholder and General Inquiries Sound Financial Bancorp, Inc. files annual, quarterly and current reports, proxy statements and other information with the SEC, which can be accessed free of charge at www.sec.gov. You also may obtain copies of the information that Sound Financial Bankcorp, Inc. files with the SEC, free of charge, by accessing the Company’s webite at www.soundcb under the tab “Investor Relations” and then “SEC Filings.” Alternateively, these documents, when available can be obtained free of charge upon written request to Sound Financial Bancorp, Chief Financial Officer, 2400 3rd Avenue, Suite 150, Seattle, Washington 98121 or by calling (206) 448-0884, extention 305. Requests for these reports, as well as inquiries from shareholders, analysts and others seeking information about Sound Financial Bancorp, Inc. should be directed to Daphne Kelley, EVP/CFO, 2400 3rd Avenue, Suite 150, Seattle Washington 98121, telephone (206) 448-0884, extension 305. The mission of Therapeutic Health Services is to foster healing and recovery through the support of individuals and families struggling with substance use and mental health issues. Therapeutic Health Services provides a unique combination of evidence based treatment, experienced and compassionate staff and culturally sensitive programs. This allows us to provide quality care for the most vulnerable in our community. We partnered with Sound Community Bank to purchase two treatment facilities. One is located in South Everett, and most recently another in the heart of Seattle. As one of the region’s largest providers of medication assisted treatment for opioid addiction, Therapeutic Health Services is on the frontline fighting the opioid epidemic. Sound Community Bank’s deep understanding of the services we provide and the importance of treatment within the community allow us to establish enduring treatment footprints in the Puget Sound region. At Therapeutic Health Services, we touch lives. With Sound Community Bank as our partner, we help patients restore their health and rebuild their future. Patricia Edmond-Quinn (cid:38)(cid:40)(cid:50) (cid:55)(cid:75)(cid:72)(cid:85)(cid:68)(cid:83)(cid:72)(cid:88)(cid:87)(cid:76)(cid:70)(cid:3)(cid:43)(cid:72)(cid:68)(cid:79)(cid:87)(cid:75)(cid:3)(cid:54)(cid:72)(cid:85)(cid:89)(cid:76)(cid:70)(cid:72)(cid:86) When I searched for a reputable bank to assist in the expansion of my manufacturing and real estate businesses in 2015, a friend recommended I contact David Sharon with Sound Community Bank. I immediately had the feeling Sound Community Bank was different from other banks. They focused on local markets and building relationships with clients, unlike my experience with the big national banks. I regularly recommend Sound Community Bank to friends and business partners! Since working closely with Sound Community Bank, Efficient Business Machines, Inc. and its subsidiaries grew tremendously and I’m confident we’ll continue growing. I want to personally thank our local Sound Community Bank team in Seattle for all their hard work in helping a small local business. As our business grows, I hope our relationship remains strong and we both benefit from this great Northwest market! Vitaliy Gutsalo, (cid:38)(cid:40)(cid:50)(cid:15)(cid:3)(cid:40)(cid:73)(cid:73)(cid:76)(cid:70)(cid:76)(cid:72)(cid:81)(cid:87)(cid:3)(cid:37)(cid:88)(cid:86)(cid:76)(cid:81)(cid:72)(cid:86)(cid:86)(cid:3)(cid:48)(cid:68)(cid:70)(cid:75)(cid:76)(cid:81)(cid:72)(cid:86)(cid:15)(cid:3)(cid:44)(cid:81)(cid:70). (cid:37)(cid:76)(cid:79)(cid:79)(cid:110)(cid:86)(cid:3)(cid:51)(cid:79)(cid:88)(cid:80)(cid:69)(cid:76)(cid:81)(cid:74)(cid:3)(cid:9)(cid:3)(cid:54)(cid:68)(cid:81)(cid:76)(cid:78)(cid:68)(cid:81)(cid:3)(cid:70)(cid:75)(cid:82)(cid:86)(cid:72)(cid:3)(cid:87)(cid:82)(cid:3)(cid:80)(cid:82)(cid:89)(cid:72)(cid:3)(cid:68)(cid:70)(cid:70)(cid:82)(cid:88)(cid:81)(cid:87)(cid:86)(cid:3)(cid:87)(cid:82)(cid:3) (cid:54)(cid:82)(cid:88)(cid:81)(cid:71)(cid:3)(cid:38)(cid:82)(cid:80)(cid:80)(cid:88)(cid:81)(cid:76)(cid:87)(cid:92)(cid:3)(cid:37)(cid:68)(cid:81)(cid:78)(cid:3)(cid:76)(cid:81)(cid:3)(cid:54)(cid:72)(cid:84)(cid:88)(cid:76)(cid:80)(cid:3)(cid:86)(cid:76)(cid:91)(cid:3)(cid:92)(cid:72)(cid:68)(cid:85)(cid:86)(cid:3)(cid:68)(cid:74)(cid:82)(cid:17)(cid:3)(cid:58)(cid:72)(cid:3) (cid:90)(cid:72)(cid:85)(cid:72)(cid:3)(cid:74)(cid:85)(cid:82)(cid:90)(cid:76)(cid:81)(cid:74)(cid:3)(cid:68)(cid:81)(cid:71)(cid:3)(cid:82)(cid:88)(cid:85)(cid:3)(cid:69)(cid:68)(cid:81)(cid:78)(cid:76)(cid:81)(cid:74)(cid:3)(cid:81)(cid:72)(cid:72)(cid:71)(cid:86)(cid:3)(cid:70)(cid:75)(cid:68)(cid:81)(cid:74)(cid:72)(cid:71)(cid:17)(cid:3)(cid:3)(cid:55)(cid:75)(cid:72)(cid:92)(cid:3) (cid:86)(cid:83)(cid:72)(cid:81)(cid:87)(cid:3)(cid:87)(cid:76)(cid:80)(cid:72)(cid:3)(cid:88)(cid:81)(cid:71)(cid:72)(cid:85)(cid:86)(cid:87)(cid:68)(cid:81)(cid:71)(cid:76)(cid:81)(cid:74)(cid:3)(cid:82)(cid:88)(cid:85)(cid:3)(cid:69)(cid:88)(cid:86)(cid:76)(cid:81)(cid:72)(cid:86)(cid:86)(cid:3)(cid:68)(cid:81)(cid:71)(cid:3)(cid:73)(cid:76)(cid:81)(cid:68)(cid:81)(cid:70)(cid:76)(cid:68)(cid:79)(cid:3) (cid:81)(cid:72)(cid:72)(cid:71)(cid:86)(cid:17)(cid:3)(cid:3)(cid:54)(cid:82)(cid:88)(cid:81)(cid:71)(cid:3)(cid:38)(cid:82)(cid:80)(cid:80)(cid:88)(cid:81)(cid:76)(cid:87)(cid:92)(cid:3)(cid:37)(cid:68)(cid:81)(cid:78)(cid:3)(cid:76)(cid:86)(cid:3)(cid:68)(cid:3)(cid:75)(cid:82)(cid:80)(cid:72)(cid:87)(cid:82)(cid:90)(cid:81)(cid:3) (cid:70)(cid:82)(cid:80)(cid:80)(cid:88)(cid:81)(cid:76)(cid:87)(cid:92)(cid:3)(cid:69)(cid:68)(cid:81)(cid:78)(cid:15)(cid:3)(cid:90)(cid:75)(cid:76)(cid:70)(cid:75)(cid:3)(cid:83)(cid:88)(cid:87)(cid:86)(cid:3)(cid:70)(cid:82)(cid:80)(cid:80)(cid:88)(cid:81)(cid:76)(cid:87)(cid:92)(cid:3)(cid:73)(cid:76)(cid:85)(cid:86)(cid:87)(cid:17)(cid:3)(cid:58)(cid:72)(cid:110)(cid:89)(cid:72)(cid:3) (cid:69)(cid:72)(cid:72)(cid:81)(cid:3)(cid:74)(cid:76)(cid:89)(cid:76)(cid:81)(cid:74)(cid:3)(cid:82)(cid:88)(cid:85)(cid:3)(cid:70)(cid:82)(cid:80)(cid:80)(cid:88)(cid:81)(cid:76)(cid:87)(cid:92)(cid:3)(cid:68)(cid:3)(cid:83)(cid:79)(cid:68)(cid:70)(cid:72)(cid:3)(cid:87)(cid:82)(cid:3)(cid:74)(cid:82)(cid:3)(cid:86)(cid:76)(cid:81)(cid:70)(cid:72)(cid:3)(cid:20)(cid:28)(cid:24)(cid:28)(cid:17)(cid:3)(cid:3) (cid:55)(cid:75)(cid:76)(cid:86)(cid:3)(cid:92)(cid:72)(cid:68)(cid:85)(cid:3)(cid:76)(cid:86)(cid:3)(cid:82)(cid:88)(cid:85)(cid:3)(cid:25)(cid:19)(cid:87)(cid:75)(cid:3)(cid:92)(cid:72)(cid:68)(cid:85)(cid:3)(cid:76)(cid:81)(cid:3)(cid:69)(cid:88)(cid:86)(cid:76)(cid:81)(cid:72)(cid:86)(cid:86)(cid:3)(cid:68)(cid:81)(cid:71)(cid:3)(cid:54)(cid:82)(cid:88)(cid:81)(cid:71)(cid:3) (cid:38)(cid:82)(cid:80)(cid:80)(cid:88)(cid:81)(cid:76)(cid:87)(cid:92)(cid:3)(cid:37)(cid:68)(cid:81)(cid:78)(cid:3)(cid:70)(cid:82)(cid:81)(cid:87)(cid:76)(cid:81)(cid:88)(cid:72)(cid:86)(cid:3)(cid:87)(cid:82)(cid:3)(cid:69)(cid:72)(cid:3)(cid:3)(cid:68)(cid:3)(cid:69)(cid:76)(cid:74)(cid:3)(cid:83)(cid:68)(cid:85)(cid:87)(cid:3)(cid:82)(cid:73)(cid:3)(cid:82)(cid:88)(cid:85)(cid:3) success. Judy Kimler (cid:51)(cid:85)(cid:72)(cid:86)(cid:76)(cid:71)(cid:72)(cid:81)(cid:87)(cid:3)(cid:9)(cid:3)(cid:38)(cid:82)(cid:16)(cid:50)(cid:90)(cid:81)(cid:72)(cid:85)(cid:3) (cid:37)(cid:76)(cid:79)(cid:79)(cid:110)(cid:86)(cid:3)(cid:51)(cid:79)(cid:88)(cid:80)(cid:69)(cid:76)(cid:81)(cid:74)(cid:3)(cid:9)(cid:3)(cid:54)(cid:68)(cid:81)(cid:76)(cid:78)(cid:68)(cid:81)(cid:15)(cid:3)(cid:44)(cid:81)(cid:70)(cid:17) (cid:79)(cid:72)(cid:73)(cid:87)(cid:3)(cid:87)(cid:82)(cid:3)(cid:85)(cid:76)(cid:74)(cid:75)(cid:87)(cid:29)(cid:3)(cid:49)(cid:68)(cid:81)(cid:70)(cid:92)(cid:3)(cid:38)(cid:82)(cid:82)(cid:81)(cid:15)(cid:3)(cid:45)(cid:88)(cid:71)(cid:92)(cid:3)(cid:46)(cid:76)(cid:80)(cid:79)(cid:72)(cid:85)(cid:15)(cid:3)(cid:46)(cid:68)(cid:85)(cid:72)(cid:81)(cid:3)(cid:47)(cid:72)(cid:90)(cid:76)(cid:86) First Step Family Support Center proudly partners with Sound Community Bank through sponsorships, helping children and families in our community thrive. With the assistance of organizations like Sound Community Bank and the wonderful staff including Julie Hatch, Business Development Officer, and Retail Manager, Laurie Szczepczynski, families feel supported and lives are enriched. At First Step, our mission is to promote the healthy development of children and families on the North Olympic Peninsula by building family strengths. Our vision is for all children to have the support needed to maximize their individual potential. Since 1972, First Step Family Support Center continues to provide free, two generational approach, prevention based education and support services to families in our community. Along with Sound Community Bank, we hope to build strong families which have the resources they need to care for themselves and information and tools to maximize their children’s development, school and future success. First Step believes supportive parents are critical to the well-being of children - parents are a child's first teachers, protectors, and emotional home. Our goal, with the amazing team at Sound Community Bank, is to ensure every child grows up feeling loved, safe, well cared for and healthy! Sound Community Bank truly is a “community” bank! Venita Lynn Executive Director, First Step Family Support Center Bluebeard Coffee Roasters began working with Sound Community Bank prior to opening in 2011. Our twin ambitions are coffee and people. Specifically, we focus on quality employees who work with us in our cafe and roastery, our Tacoma community, and those working hard to grow and process unique and compelling coffees at the source. Halfway around the world where we buy coffee, our mission is to find people we love to do business and visit with, while growing wonderful coffee. Just halfway across town, Sound Community Bank embodies that same ideal. We love going to visit with our friends at the Tacoma branch each week and carry out our banking. The fact they are the exact people we need to continue the growth and support of our business simply feels like a bonus. Big time bank, hometown vibe. Thanks, Sound Community Bank! Kevin McGlocklin, Owner, Bluebeard Coffee Roasters For the past 10 years I have worked with Sound Community Bank, primarily as a commercial lending client. To put it simply, it is - and continues to be - a great experience. While my needs are generally pretty straightforward, each project is unique, and the lending team takes the time to get to know each project and understand it while assembling documentation. There were no surprises over the years, and the approach and standards remain consistent. When a project became tricky with an investor, I felt Sound Community Bank had my back. I continue to receive a quality banking experience, even without a branch close to my home. Between online banking, the mobile application, and the occasional phone call to the Seattle branch, I easily take care of my personal banking as well! Graham Black Owner, gProjects (cid:49)(cid:82)(cid:85)(cid:87)(cid:75)(cid:3)(cid:50)(cid:79)(cid:92)(cid:80)(cid:83)(cid:76)(cid:70)(cid:3)(cid:51)(cid:72)(cid:81)(cid:76)(cid:81)(cid:86)(cid:88)(cid:79)(cid:68)(cid:3)(cid:72)(cid:80)(cid:83)(cid:79)(cid:82)(cid:92)(cid:72)(cid:72)(cid:86)(cid:3)(cid:68)(cid:81)(cid:71)(cid:3)(cid:73)(cid:68)(cid:80)(cid:76)(cid:79)(cid:92)(cid:3)(cid:80)(cid:72)(cid:80)(cid:69)(cid:72)(cid:85)(cid:86)(cid:3) (cid:74)(cid:68)(cid:87)(cid:75)(cid:72)(cid:85)(cid:3)(cid:68)(cid:87)(cid:3)(cid:87)(cid:75)(cid:72)(cid:3)(cid:20)(cid:21)(cid:22)(cid:85)(cid:71)(cid:3)(cid:44)(cid:85)(cid:85)(cid:76)(cid:74)(cid:68)(cid:87)(cid:76)(cid:82)(cid:81)(cid:3)(cid:41)(cid:72)(cid:86)(cid:87)(cid:76)(cid:89)(cid:68)(cid:79)(cid:3)(cid:38)(cid:85)(cid:68)(cid:93)(cid:92)(cid:3)(cid:39)(cid:68)(cid:93)(cid:72)(cid:3)(cid:37)(cid:85)(cid:72)(cid:68)(cid:78)(cid:73)(cid:68)(cid:86)(cid:87)(cid:17)(cid:3)(cid:3) (cid:55)(cid:75)(cid:72)(cid:3)(cid:44)(cid:85)(cid:85)(cid:76)(cid:74)(cid:68)(cid:87)(cid:76)(cid:82)(cid:81)(cid:3)(cid:41)(cid:72)(cid:86)(cid:87)(cid:76)(cid:89)(cid:68)(cid:79)(cid:3)(cid:76)(cid:86)(cid:3)(cid:87)(cid:75)(cid:72)(cid:3)(cid:79)(cid:82)(cid:81)(cid:74)(cid:72)(cid:86)(cid:87)(cid:3)(cid:85)(cid:88)(cid:81)(cid:81)(cid:76)(cid:81)(cid:74)(cid:3)(cid:73)(cid:72)(cid:86)(cid:87)(cid:76)(cid:89)(cid:68)(cid:79)(cid:3)(cid:76)(cid:81)(cid:3)(cid:87)(cid:75)(cid:72)(cid:3) State of Washington. 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D.C. 20549 FORM 10-K ☒ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2018 OR □ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to COMMISSION FILE NUMBER 001-35633 Sound Financial Bancorp, Inc. (Exact Name of Registrant as Specified in its Charter) Maryland (State or other jurisdiction of incorporation or organization) 45-5188530 (I.R.S. Employer Identification No.) 2400 3rd Avenue, Suite 150, Seattle Washington (Address of principal executive offices) 98121 (Zip Code) Registrant’s telephone number, including area code: (206) 448-0884 Securities Registered Pursuant to Section 12(b) of the Act: Common Stock, par value $.01 per share Securities Registered Pursuant to Section 12(g) of the Act: Title of each class None Indicate by checkmark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. YES □ NO ☒ Indicate by checkmark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. YES □ NO ☒ Indicate by checkmark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES ☒ NO □ Indicate by checkmark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). YES ☒ NO □ Indicate by checkmark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ☒ Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definition of ‘‘large accelerated filer,’’ accelerated filer,’’ ‘‘smaller reporting company’’ and ‘‘emerging growth company’’ in Rule 12b-2 of the Exchange Act. Large accelerated filer □ Non-accelerated filer □ Accelerated filer ☒ Smaller reporting company ☒ Emerging growth company □ If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. □ Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES □ NO ☒ The aggregate market value of the voting and non-voting common equity held by non-affiliates as of June 30, 2018, the last business day of the registrant’s most recently completed second fiscal quarter, was approximately $82.4 million. (The exclusion from such amount of the market value of the shares owned by any person shall not be deemed an admission by the registrant that such person is an affiliate of the registrant.) Indicate the number of shares outstanding of each of the registrant’s classes of common stock as of the latest practicable date: As of March 12, 2019, there were 2,547,236 shares of the registrant’s common stock outstanding. PART III of Form 10-K – Portions of the Registrant’s Proxy Statement for its 2019 Annual Meeting of Shareholders. DOCUMENTS INCORPORATED BY REFERENCE SOUND FINANCIAL BANCORP, INC. FORM 10-K TABLE OF CONTENTS PART I Item 1. Item 1A. Item 1B. Item 2. Item 3. Item 4. PART II Item 5. Item 6. Item 7. Item 7A. Item 8. Item 9. Item 9A. Item 9B. PART III Item 10. Item 11. Item 12. Item 13. Item 14. PART IV Business. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Risk Factors. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unresolved Staff Comments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Properties. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mine Safety Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Selected Financial Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Management’s Discussion and Analysis of Financial Condition and Results of Operations . . . Quantitative and Qualitative Disclosures About Market Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . Financial Statements and Supplementary Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Changes in and Disagreements With Accountants on Accounting and Financial Disclosure . . . Controls and Procedures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Directors, Executive Officers and Corporate Governance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Executive Compensation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Certain Relationships and Related Transactions, and Director Independence . . . . . . . . . . . . . . . Principal Accounting Fees and Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Item 15. Item 16. Exhibits, Financial Statement Schedules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Form 10-K Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Signatures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Power of Attorney . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 3 37 37 37 38 38 39 40 42 56 58 100 100 101 102 103 103 103 103 104 106 107 107 Certifications Exhibit 31.1 Exhibit 31.2 Exhibit 32 Item 1. Business Special Note Regarding Forward-Looking Statements PART I Certain matters discussed in this Form 10-K 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: • • • • • • • • • • • • • • • our ability to access cost-effective funding; our ability to attract and retain deposits; fluctuations in interest rates; the risks of lending and investing activities, including changes in the level and direction of loan delinquencies and write-offs and changes in estimates of the adequacy of our allowance for loan losses; inability of key third-party providers to perform their obligations to us; fluctuations in the demand for loans, the number of unsold homes, land and other properties, and fluctuations in real estate values and both residential and commercial and multifamily real estate market conditions in our market area; secondary market conditions for loans and our ability to sell loans in the secondary market; 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; 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; our ability to control operating costs and expenses; the use of estimates in determining fair value of certain of our assets, which estimates may prove to be incorrect and result in significant declines in valuation; 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; competitive pressures among financial services companies; changes in consumer spending, borrowing and savings habits; 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; 3 • • changes in economic conditions, either nationally or in our market area; legislative or regulatory changes such as the Dodd-Frank Wall Street Reform and Consumer Protection Act (the ‘‘Dodd-Frank Act’’) and its implementing regulations that adversely affect our business, as well as changes in regulatory policies and principles, or the interpretation of regulatory capital or other rules including changes related to Basel III; • 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; • • • • • • • • • • • 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; difficulties in reducing risks associated with the loans on our balance sheet; staffing fluctuations in response to product demand or the implementation of corporate strategies that affect our workforce and potential associated charges; our ability to pay dividends on our common stock; the availability of resources to address changes in laws, rules, or regulations or to respond to regulatory actions; our ability to pay dividends on our common stock; the possibility of other-than-temporary impairments of securities held in our securities portfolio; adverse changes in the securities markets; and other economic, competitive, governmental, regulatory, and technological factors affecting our operations, pricing, products and services and the other risks described from time to time in this Form 10-K and our other filings with the U.S. Securities and Exchange Commission (the ‘‘SEC’’). We wish to advise readers not to place undue reliance on any forward-looking statements and that the factors listed above could materially affect our financial performance and could cause our actual results for future periods to differ materially from any such forward-looking statements expressed with respect to future periods and could negatively affect our stock price performance. We do not undertake and specifically decline any obligation to publicly release the result of any revisions which may be made to any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events. General References in this document to Sound Financial Bancorp or the Company refer to Sound Financial Bancorp, Inc. and references to the ‘‘Bank’’ refer to Sound Community Bank. References to ‘‘we,’’ ‘‘us,’’ and ‘‘our’’ means Sound Financial Bancorp and its wholly-owned subsidiary, Sound Community Bank, unless the context otherwise requires. 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 State Department of Financial Institutions (‘‘WDFI’’) and the Federal Deposit Insurance Corporation (‘‘FDIC’’). The Federal Reserve is the primary federal regulator for Sound Financial Bancorp. We also sell insurance products and services for consumer 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 December 31, 2018, Sound Financial Bancorp had total consolidated assets of $716.7 million, loans held for portfolio of 4 $619.5 million, deposits of $553.6 million and stockholders’ equity of $71.6 million. The shares of Sound Financial Bancorp are traded on The NASDAQ Capital Market under the symbol ‘‘SFBC.’’ Our executive offices are located at 2400 3rd Avenue, Suite 150, Seattle, Washington, 98121 and our telephone number is 206-448-0884. Our principal business consists of attracting retail and commercial deposits from the general public and investing those funds, along with borrowed funds, in loans secured by first and second mortgages on one- to four-family residences (including home equity loans and lines of credit), commercial and multifamily real estate, construction and land, consumer and commercial business loans. Our commercial business loans include unsecured lines of credit and secured term loans and lines of credit secured by inventory, equipment and accounts receivable. We also offer a variety of secured and unsecured consumer loan products, including manufactured home loans, floating home loans, automobile loans, boat loans and recreational vehicle loans. As part of our business, we focus on residential mortgage loan originations, a portion of which we sell to Fannie Mae 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 released. 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. Market Area We serve the Seattle Metropolitan Statistical Area (‘‘MSA’’), which includes King County (which includes the city of Seattle), Pierce County and Snohomish County within the Puget Sound region, and also serve Clallam and Jefferson Counties, on the North Olympic Peninsula of Washington. We serve these markets through our headquarters in Seattle, eight branch offices, five of which are located in the Seattle MSA, two that are located in Clallam County and one that is located in Jefferson County. We also have two loan production offices, one located in the Madison Park neighborhood of Seattle and one located in Sequim. Based on the most recent branch deposit data provided by the FDIC, our share of deposits was approximately 0.14% in King County, approximately 0.41% in Pierce County and in Snohomish County approximately 0.33%. In Clallam County and Jefferson County, we have approximately 16.5% and 6.8%, respectively, of the deposits in those markets. See ‘‘– Competition.’’ Our market area includes a diverse population of management, professional and sales personnel, office employees, health care workers, manufacturing and transportation workers, service industry workers and government employees, as well as retired and self-employed individuals. The population has a skilled work force with a wide range of education levels and ethnic backgrounds. Major employment sectors include information and communications technology, financial services, manufacturing, maritime, biotechnology, education, health and social services, retail trades, transportation and professional services. The largest employers headquartered in our market area include U.S. Joint Base Lewis-McChord, Navy Region Northwest, Microsoft, University of Washington, and Providence Health. Other significant employers include Costco, Boeing, Nordstrom, Amazon.com, Starbucks, Alaska Air Group and Weyerhaeuser. Economic conditions in our markets continue to improve over the last year. Recent trends in housing prices and unemployment rates in our market areas reflect continuing improvement. For the month of December 2018, the preliminary Seattle metropolitan statistical area (MSA) reported an unemployment rate of 3.3%, as compared to the national average of 3.9%, according to the latest available information from the Bureau of Labor Statistics. Home prices in our markets also improved over the past year. Based on information from Case-Shiller, the average home price in the Seattle MSA increased 4.8% in 2018. This compares favorably to the national average home price index increase in 2018 of 4.5%. King County has the largest population of any county in the state of Washington, covers approximately 2,100 square miles, and is located on Puget Sound. It has approximately 2.2 million residents and a median household income of approximately $82,000. King County has a diversified economic base with many employers from various industries including shipping and transportation, retail, aerospace, and computer technology and biotech industries. Based on information from the Northwest Multiple Listing Service (‘‘MLS’’), the median home sales price in King County in December 2018 was $597,000, a 2.1% increase from December 2017’s median home sales price of $585,000. 5 Pierce County covers approximately 1,700 square miles and is located along the southwestern Puget Sound and borders southern King County. It has approximately 861,000 residents and a median household income of approximately $61,000. The Pierce County economy is diversified with the presence of military related government employment, transportation and shipping employment, and aerospace related employment. Based on information from the MLS, the median home sales price in Pierce County in December 2018 was $340,000, a 7.9% increase from December 2017’s median home sales price of $315,000. Snohomish County covers approximately 2,100 square miles and is located on Puget Sound touching the northern border of King County. It has approximately 789,000 residents and a median household income of approximately $76,000. The economy of Snohomish County is diversified with the presence of military related government employment, aerospace related employment, and retail trade. Based on information from the MLS, the median home sales price in Snohomish County as of December 2018 was $455,000, a 7.0% increase from December 2017’s median home sales price of $425,000. Clallam County, with a population of approximately 75,000, is bordered by the Pacific Ocean and the Strait of Juan de Fuca and covers 1,700 square miles, including the westernmost portion of the continental United States. It has a median household income of approximately $47,000. The economy of Clallam County is primarily manufacturing and shipping. The Sequim Dungeness Valley continues to be a growing retirement location. Our offices are in Port Angeles and Sequim, the two largest cities in the county. Based on information from the MLS, the median home sales price in Clallam County in December 2018 was $270,000, an 8.3% decrease from December 2017’s median home sales price of $295,000. Jefferson County, with a population of approximately 31,000, is bordered by Clallam County and the Pacific Ocean to the west and Hood Canal on the east and covers 1,800 square miles. The economy of Jefferson County is primarily based on tourism, agriculture, lumber, fish processing and ship repair and maintenance. It has a median household income of approximately $49,000. Based on information from the MLS, the average home sales price in Jefferson County as of December 2018 was $335,000, a 7.5% decrease from December 2017’s median home sales price of $362,000. According to the latest available information from the Bureau of Labor Statistics, King and Snohomish Counties reported an unemployment rate of 3.3% and 3.6%, respectively, as of December 2018, as compared to the state and national unemployment rates of 4.3% and 3.9%, respectively. The unemployment rates for Clallam, Pierce and Jefferson Counties were above the state and national rates as of December 2018. The unemployment rate in Clallam County decreased to 6.9% as of December 2018 from 7.0% as of December 2017, while the unemployment rate in Pierce County decreased to 5.3% as of December 2018 from 5.4% as of December 2017. The unemployment rate in Jefferson County decreased to 5.9% as of December 2018 from 6.2% as of December 2017. 6 Lending Activities The following table presents information concerning the composition of our loan portfolio, excluding loans held-for-sale, by the type of loan for the dates indicated (dollars in thousands): December 31, 2016 Amount Percent Amount Percent Amount Percent Amount Percent Amount Percent 2014 2017 2018 2015 Real estate loans: One- to four-family . . . . . . . . Home equity . . . . . . . . . . . . Commercial and multifamily . . Construction and land. . . . . . . $169,830 27,655 252,644 65,259 27.3% $157,417 4.4% 28,379 40.6% 211,269 10.6% 61,482 28.5% $152,386 27,771 5.2 181,004 38.4 70,915 11.2 30.3% $141,125 31,573 175,312 57,043 5.5 36.1 14.1 30.5% $133,031 34,675 168,952 46,279 6.9 38.0 12.4 30.9% 8.0 39.1 10.7 Total real estate loans. . . . . 515,388 82.9% 458,547 83.3 432,076 86.0 405,053 87.8 382,937 88.7 Consumer loans: Manufactured homes . . . . . . . Floating homes . . . . . . . . . . . Other consumer. . . . . . . . . . . Total consumer loans . . . . . Commercial business loans . . 20,145 40,806 6,628 67,579 38,804 3.2% 17,111 6.6% 29,120 4,902 1.1% 10.9% 51,133 6.2% 40,829 3.1 5.3 0.9 9.3 7.4 15,494 23,996 3,932 43,422 26,331 3.1 4.8 0.8 8.7 5.3 13,798 18,226 4,804 36,828 19,295 3.0 4.0 1.0 8.0 4.2 12,539 11,680 5,195 29,414 19,525 2.9 2.7 1.2 6.8 4.5 Total loans . . . . . . . . . . . . . . 621,771 100.00% 550,509 100.0% 501,829 100.0% 461,176 100.0% 431,876 100.0% Less: Deferred fees and discounts . . . Allowance for loan losses . . . . (2,228) (5,774) Total loans, net . . . . . . . . . $613,769 (1,914) (5,241) $543,354 (1,828) (4,822) $495,179 (1,707) (4,636) $454,833 (1,516) (4,387) $425,973 The following table shows the composition of our loan portfolio in dollar amounts and in percentages by fixed and adjustable rate loans for the dates indicated (dollars in thousands): December 31, 2016 Amount Percent Amount Percent Amount Percent Amount Percent Amount Percent 2017 2018 2014 2015 Fixed-rate loans: Real estate loans: One- to four-family . . . . . . . . Home equity . . . . . . . . . . . . Commercial and multifamily . . Construction and land. . . . . . . $ 94,237 11,052 102,907 51,259 15.2% $117,590 11,373 89,094 57,247 1.8 16.5 8.2 21.3% $142,537 9,102 77,285 69,398 2.1 16.2 10.4 28.4% $129,762 11,042 92,205 51,572 1.8 15.4 13.9 28.1% $118,083 12,003 2.4 103,303 20.0 39,147 11.2 27.3% 2.8 23.9 9.1 Total real estate loans. . . . . 259,455 41.7 275,304 50.0 298,322 59.5 284,581 61.7 272,536 63.1 Manufactured homes . . . . . . . Floating homes . . . . . . . . . . . Other consumer. . . . . . . . . . . Commercial business . . . . . . . 20,145 40,806 6,090 9,705 3.2 6.6 1.0 1.6 17,111 29,120 4,316 16,889 3.1 5.3 0.8 3.1 15,494 23,996 3,297 12,581 3.1 4.8 0.6 2.5 13,798 18,226 4,082 9,392 3.0 4.0 0.9 2.0 12,539 11,680 4,447 11,024 2.9 2.7 1.0 2.6 Total fixed-rate loans . . . . . 336,201 54.1 342,740 62.3 353,690 70.5 330,079 71.6 312,226 72.3 Adjustable- rate loans: Real estate loans: One- to four-family . . . . . . . . Home equity . . . . . . . . . . . . Commercial and multifamily . . Construction and land. . . . . . . 75,593 16,603 149,737 14,000 Total real estate loans. . . . . 255,933 Other consumer. . . . . . . . . . . Commercial business . . . . . . . 538 29,099 12.2 2.7 24.0 2.3 41.2 0.1 4.6 39,827 17,007 122,175 4,235 183,244 585 23,940 7.2 3.1 22.2 0.8 33.3 0.1 4.3 9,849 18,669 103,719 1,517 133,754 635 13,750 2.0 3.7 20.7 0.3 26.7 0.1 2.7 11,363 20,531 83,107 5,471 120,472 722 9,903 2.5 4.4 18.0 1.2 26.1 0.2 2.1 14,948 22,672 65,649 7,132 110,401 746 8,501 3.5 5.3 15.2 1.6 25.6 0.2 2.0 Total adjustable-rate loans . . 285,570 45.9 207,769 37.7 148,139 29.5 131,097 28.4 119,648 27.7 Total loans . . . . . . . . . . . . . . 621,771 100.0% 550,509 100.0% 501,829 100.0% 461,176 100.0% 431,874 100.0% Less: Deferred fees and discounts . . . Allowance for loan losses . . . . (2,228) (5,774) Total loans, net . . . . . . . . . $613,769 (1,914) (5,241) $543,354 (1,828) (4,822) $495,179 (1,707) (4,636) $454,833 (1,516) (4,387) $425,971 7 The following table illustrates the contractual maturity of our construction and land and commercial business loans at December 31, 2018 (dollars in thousands). Loans that have adjustable or renegotiable interest rates are shown as maturing in the period during which the contract is due. The total amount of loans due after December 31, 2019, which have predetermined interest rates, is $24.6 million, while the total amount of loans due after such date, which have floating or adjustable interest rates, is $13.0 million. The table does not reflect the effects of possible prepayments or enforcement of due-on-sale clauses. Amount 2019(1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . $45,844 16,497 2020 to 2023 . . . . . . . . . . . . . . . . . . . . . . . 2024 and thereafter . . . . . . . . . . . . . . . . . . 2,918 Total(2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . $65,259 Construction and Land Weighted Average Rate Commercial Business Weighted Average Rate Amount Total Amount Weighted Average Rate 5.80% $20,641 10,334 6.85 7,829 6.44 5.96% $ 66,485 26,831 5.54 10,747 5.69 6.10% $38,804 5.79% $104,063 5.85% 6.34 5.89 5.98% (1) Includes demand loans, loans having no stated maturity and overdraft loans. (2) Excludes deferred fees of $538,000. Lending Authority. Our President and Chief Executive Officer (‘‘CEO’’) may approve unsecured loans up to $1.0 million and all types of secured loans up to 30% of our legal lending limit, or approximately $4.6 million as of December 31, 2018. Our Executive Vice President and Chief Credit Officer (‘‘CCO’’) may approve unsecured loans up to $400,000 and secured loans up to 15% of our legal lending limit, or approximately $2.3 million as of December 31, 2018. Any loans over the CEO’s lending authority or loans significantly outside our general underwriting guidelines must be approved by the Loan Committee consisting of four independent directors, the CEO and the CCO. Lending authority is also granted to certain other lending staff at lower amounts. The Business Banking Team Leader has lending authority of up to 7.5% of our legal lending limit for real estate and other secured loans, and $50,000 for unsecured loans. The Residential Lending Team Leader has lending authority up to 7.5% of our legal lending limit for real estate and other secured loans, and $5,000 for unsecured loans. Largest Borrowing Relationships. At December 31, 2018, the maximum amount under federal law that we could lend to any one borrower and the borrower’s related entities was approximately $15.5 million. Our five largest relationships totaled $54.4 million in the aggregate, or 8.8% of our $621.8 million total loan portfolio, at December 31, 2018. At December 31, 2018, the largest lending relationship totaled $12.2 million consisting of three loans to businesses with common ownership and separately two loans to an individual, all collateralized by multifamily real estate. The second largest relationship consisted of five loans to businesses with common ownership, were collateralized by multifamily real estate and totaled $11.7 million. The third, fourth and fifth largest relationships consisted of a $10.5 million commercial business line of credit loan participation to a third party loan originator secured by an assignment of promissory notes from their borrowers for residential mortgage loans, a $10.0 million business line of credit loan participation to a third party loan originator secured by an assignment of promissory notes from their borrowers for construction projects, and two business line of credit loan participations totaling $10.0 million to third party loan originators with common ownership, collateralized by an assignment of promissory notes from their borrowers for construction projects. Undistributed construction loan commitments on these lines of credit were $6.4 million, $4.4 million and $2.6 million, respectively. At December 31, 2018, we had five other lending relationships that exceeded $6.3 million. All of the foregoing loans were performing in accordance with their repayment terms as of December 31, 2018. One- to Four-Family Real Estate Lending. One of our primary lending activities is the origination of loans secured by first mortgages on one- to four-family residences, substantially all of which are secured by property located in our geographic lending area. We originate both fixed-rate and adjustable-rate loans. During 2018, our fixed rate, one- to four-family loan originations decreased $5.7 million, or 7.8% to $67.8 million compared to $73.6 million in 2017. In 2018, the Bank identified continued demand in the marketplace for one- to four-family, residential adjustable rate mortgage loans (‘‘ARM’’), especially jumbo loans (loans above $453,100, the conforming Fannie Mae limit in our market area). As a result, our adjustable rate one- to four-family, residential loan originations increased $8.6 million, or 23.8% to $44.7 million compared to $36.1 million in 2017. In 2018, the average loan amount was $639,000 for adjustable rate, one- to four-family mortgages. 8 Most of our loans are underwritten using generally-accepted secondary market underwriting guidelines. A portion of the one- to four-family loans we originate are retained in our portfolio and the remaining loans are sold into the secondary market to Fannie Mae or other private investors. Loans that are sold into the secondary market to Fannie Mae are sold with the servicing retained to maintain the client relationship and to generate noninterest income. We also originate a small portion of government guaranteed and jumbo loans for sale servicing released to certain correspondent purchasers. The sale of mortgage loans provides a source of non-interest income through the gain on sale, reduces our interest rate risk, provides a stream of servicing income, enhances liquidity and enables us to originate more loans at our current capital level than if we held the loans in our loan portfolio. Our pricing strategy for mortgage loans includes establishing interest rates that are competitive with other financial institutions and consistent with our internal asset and liability management objectives. At December 31, 2018, one-to four-family residential mortgage loans (excluding loans held-for-sale) totaled $169.8 million, or 27.3 %, of our gross loan portfolio, of which $94.2 million were fixed-rate loans and $75.6 million were ARM loans, compared to $157.4 million (excluding loans held-for-sale), or 28.5 % of our gross loan portfolio as of December 31, 2017, of which $117.6 million were fixed-rate loans and $39.8 million were ARM loans. Substantially all of the one- to four-family residential mortgage loans we retain in our portfolio consist of loans that do not satisfy acreage limits, income, credit, conforming loan limits (i.e., jumbo mortgages) or various other requirements imposed by Fannie Mae or private investors. Some of these loans are also originated to meet the needs of borrowers who cannot otherwise satisfy Fannie Mae credit requirements because of personal and financial reasons (i.e., bankruptcy, length of time employed, etc.), and other aspects, which do not conform to Fannie Mae’s guidelines. Such borrowers may have higher debt-to-income ratios, or the loans are secured by unique properties in rural markets for which there are no sales of comparable properties to support the value according to secondary market requirements. We may require additional collateral or lower loan-to-value ratios to reduce the risk of these loans. We believe that these loans satisfy the needs of borrowers in our market area. As a result, subject to market conditions, we intend to continue to originate these types of loans. We also retain jumbo loans which exceed the conforming loan limits and therefore, are not eligible to be purchased by Fannie Mae. At December 31, 2018, $79.8 million or 47.0 % of our one-to four-family loan portfolio consisted of jumbo loans. We generally underwrite our one- to four-family loans based on the applicant’s employment and credit history and the appraised value of the subject property. We generally lend up to 80% of the lesser of the appraised value or purchase price for one- to four-family first mortgage loans and non-owner occupied first mortgage loans. For first mortgage loans with a loan-to-value ratio in excess of 80%, we may require private mortgage insurance or other credit enhancement to help mitigate the risk. Properties securing our one- to four-family loans are typically appraised by independent fee appraisers who are selected in accordance with criteria approved by the Loan Committee. For loans that are less than $250,000, we may use an automated valuation model, in lieu of an appraisal. We require title insurance policies on all first mortgage real estate loans originated. Homeowners, liability, fire and, if required, flood insurance policies are also required for one-to four-family loans. Our real estate loans generally contain a ‘‘due on sale’’ clause allowing us to declare the unpaid principal balance due and payable upon the sale of the security property. The average balance of our one- to four-family residential loans was approximately $317,000 at December 31, 2018. Fixed-rate loans secured by one- to four-family residences have contractual maturities of up to 30 years. All of these loans are fully amortizing, with payments due monthly. Our portfolio of fixed-rate loans also includes $7.5 million of loans with an initial seven year term and a 30-year amortization period with a borrower refinancing option at a fixed rate at the end of the initial term as long as the loan has met certain performance criteria. In addition, we had $22.9 million one- to four-family loans with a five-year call option at December 31, 2018. Prior to 2012, we originated for portfolio five and seven year balloon reset loans (which are loans that are originated with a fixed interest rate for the initial five or seven years, and thereafter incur one interest rate change based on current market interest rates in which the new rate remains in effect for the remainder of the loan term) based on a 30-year amortization period. ARM loans are offered with annual adjustments and life-time rate caps that vary based on the product, generally with a maximum annual rate change of 2.0% and a maximum overall rate change of 6.0%. We generally use the rate on one-year LIBOR to re-price our ARM loans, however, $6.1 million of our ARM loans are to employees and directors that re-price annually based on a margin of 1%-1.5% over our average 12 month cost of funds. As a consequence of using caps, the interest rates on ARM loans may not be as rate sensitive as our cost of funds. Furthermore, because loan indexes may not respond perfectly to changes in market interest rates, upward 9 adjustments on loans may occur more slowly than increases in our cost of interest-bearing liabilities, especially during periods of rapidly increasing interest rates. Because of these characteristics, future yields on ARM loans may not be sufficient to offset increases in our cost of funds. We continue to offer our fully amortizing ARM loans with a fixed interest rate for the first one, three, five or seven years, followed by a periodic adjustable interest rate for the remaining term. Given the recent increase in market rates over the past year, the origination of ARM loans has increased significantly as borrowers are beginning to favor ARM loans over fixed-rate mortgages. Although adjustable-rate mortgage loans may reduce to an extent our vulnerability to changes in market interest rates because they periodically re-price, as interest rates increase the required payments due from the borrower also increase (subject to rate caps), increasing the potential for default by the borrower. At the same time, the ability of the borrower to repay the loan and the marketability of the underlying collateral may be adversely affected by higher interest rates. Upward adjustments of the contractual interest rate are also limited by our maximum periodic and lifetime rate adjustments. Moreover, the interest rates on most of our adjustable-rate loans do not adjust within the next year and may not adjust for up to ten years after origination. As a result, the effectiveness of adjustable-rate mortgage loans in compensating for changes in general interest rates may be limited during periods of rapidly rising interest rates. At December 31, 2018, $50.2 million, or 29.6% of our one- to four-family residential portfolio consisted of non-owner occupied loans, compared to $42.4 million or 26.9% of our one- to four-family residential portfolio at December 31, 2017. Loans secured by rental properties represent potentially higher risk and, as a result, we adhere to more stringent underwriting guidelines. Of primary concern in non-owner occupied real estate lending is the consistency of rental income of the property. Payments on loans secured by rental properties may depend primarily on the tenants’ continuing ability to pay rent to the property owner, the character of the borrower or, if the property owner is unable to find a tenant, the property owner’s ability to repay the loan without the benefit of a rental income stream. In addition, successful operation and management of non-owner occupied properties, including property maintenance standards, may affect repayment. As a result, repayment of such loans may be subject to adverse conditions in the real estate market or the economy. We may request that borrowers and loan guarantors, if any, provide annual financial statements, a budget factoring in a rental income cash flow analysis of the borrower as well as the net operating income of the property, information concerning the borrower’s expertise, credit history and profitability, and the value of the underlying property. These loans are generally secured by a first mortgage on the underlying collateral property along with an assignment of rents and leases. If the borrower has multiple rental property loans with us, the loans are typically not cross collateralized. In 2016, in order to enable individuals to secure the purchase of a new residence before selling their existing residence, we commenced a loan program designed to allow borrowers to access the equity in their current residence to apply towards the purchase of a new residence. The loan or loans to purchase the new residence are generally originated in an amount in excess of $1.0 million and secured by the borrowers existing and/or new residences, with a maximum combined LTV of up to 80%. These loans provide for repayment upon the earlier of the sale of the current residence or the loan maturity date, which is typically up to 12 months. Upon the sale of the borrower’s current residence, we may refinance the new residence using our traditional jumbo mortgage loan underwriting guidelines. During 2018, we originated $4.9 million of loans under this program compared to $15.6 million in 2017. At December 31, 2018, we had $10.2 million of these interest only residential loans in our one- to four-family residential mortgage loan portfolio. The primary focus of our underwriting guidelines for interest only residential loans is on the value of the collateral rather than the ability of the borrower to repay the loan. As a result, this type of lending exposes us to an increased risk of loss due to the larger loan balance and our inability to sell them to Fannie Mae, similar to the risks associated with jumbo one- to four-family residential loans. In addition, a decline in residential real estate values resulting from a downturn in the Washington housing market may reduce the value of the real estate collateral securing these types of loans and increase our risk of loss if borrowers default on their loans. Home Equity Lending. We originate home equity loans that consist of fixed-rate fully amortizing loans and variable-rate lines of credit. We typically originate home equity loans in amounts of up to 90% of the value of the collateral, minus any senior liens on the property; however, prior to 2010 we originated home equity loans in amounts of up to 100% of the value of the collateral, minus any senior liens on the property. Home equity lines of credit are typically originated for up to $250,000 with an adjustable rate of interest, based on the one-year Treasury Bill rate or the Wall Street Journal Prime rate, plus a margin. Home equity lines of credit generally have a three, five or 12 year draw period, during which time the funds may be paid down and redrawn up to the 10 committed amount. Once the draw period has lapsed, the payment is amortized over either a 12, 19 or 21 year period based on the loan balance at that time. We charge a $50 annual fee on each home equity line of credit and require monthly interest-only payments on the entire amount drawn during the draw period. At December 31, 2018, home equity loans totaled $27.7 million, or 4.4% of our total loan portfolio compared to $28.4 million, or 5.2% of our total loan portfolio at December 31, 2017. Adjustable-rate home equity lines of credit at December 31, 2018 totaled $16.6 million, or 2.7 % of our total loan portfolio, compared to $17.0 million, or 3.1 % of our total loan portfolio as of December 31, 2017. At December 31, 2018, unfunded commitments on home equity lines of credit totaled $12.5 million. Our fixed-rate home equity loans generally have terms of up to 15 years and are fully amortizing. At December 31, 2018, fixed-rate home equity loans totaled $11.1 million, or 1.8% of our gross loan portfolio, compared to $11.4 million, or 2.1% of our total loan portfolio as of December 31, 2017. Commercial and Multifamily Real Estate Lending. We offer a variety of commercial and multifamily real estate loans. Most of these loans are secured by owner-occupied and non-owner-occupied commercial income producing properties, multifamily apartment buildings, warehouses, office buildings, gas station/convenience stores and mobile home parks located in our market area. At December 31, 2018, commercial and multifamily real estate loans totaled $252.6 million, or 40.6% of our total loan portfolio, compared to $211.3 million, or 38.4 % of our total loan portfolio as of December 31, 2017. Loans secured by commercial and multifamily real estate are generally originated with a variable interest rate, fixed for an initial three to ten-year term and a 20- to 25-year amortization period. At the end of the initial term, the balance is due in full or the loan re-prices based on an independent index plus a margin over the applicable index of 1% to 4% for another five years. Loan-to-value ratios on our commercial and multifamily real estate loans typically do not exceed 80% of the lower of cost or appraised value of the property securing the loan at origination. Loans secured by commercial and multifamily real estate are generally underwritten based on the net operating income of the property, quality and location of the real estate, the credit history and financial strength of the borrower and the quality of management involved with the property. The net operating income, which is the income derived from the operation of the property less all operating expenses, must be sufficient to cover the payments related to the outstanding debt plus an additional coverage requirement. We generally impose a minimum debt service coverage ratio of 1.20 for originated loans secured by income producing commercial properties. If the borrower is other than an individual, we typically require the personal guaranty of the principal owners of the borrowing entity. We also generally require an assignment of rents in order to be assured that the cash flow from the project will be used to repay the debt. Appraisals on properties securing commercial and multifamily real estate loans are performed by independent state certified licensed fee appraisers. In order to monitor the adequacy of cash flows on income-producing properties, the borrower is required to provide annual financial information. From time to time we also acquire participation interests in commercial and multifamily real estate loans originated by other financial institutions secured by properties located in our market area. Historically, loans secured by commercial and multifamily properties generally involve different credit risks than one- to four-family properties. These loans typically involve larger balances to single borrowers or groups of related borrowers. Because payments on loans secured by commercial and multifamily properties are often dependent on the successful operation or management of the properties, repayment of these loans may be subject to adverse conditions in the real estate market or the economy. Repayments of loans secured by non owner occupied properties depend primarily on the tenant’s continuing ability to pay rent to the property owner, who is our borrower, or, if the property owner is unable to find a tenant, the property owner’s ability to repay the loan without the benefit of a rental income stream. If the cash flow from the project is reduced, or if leases are not obtained or renewed, the borrower’s ability to repay the loan may be impaired. Commercial and multifamily real estate loans also expose a lender to greater credit risk than loans secured by one- to four-family because the collateral securing these loans typically cannot be sold as easily as one- to four-family. In addition, most of our commercial and multifamily real estate loans are not fully amortizing and include balloon payments upon maturity. Balloon payments may require the borrower to either sell or refinance the underlying property in order to make the payment, which may increase the risk of default or non-payment. The largest single commercial and multifamily real estate loan at December 31, 2018, totaled $7.3 million and is collateralized by an office building. At December 31, 2018, this loan was performing in accordance with its repayment terms. 11 The following table provides information on commercial and multifamily real estate loans by type at December 31, 2018 and 2017 (dollars in thousands): 2018 2017 Amount Percent Amount Percent Multifamily residential. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Owner-occupied commercial real estate retail . . . . . . . . . . . . . . . . . . Owner-occupied commercial real estate office buildings. . . . . . . . . . Owner-occupied commercial real estate other(1) . . . . . . . . . . . . . . . . Non Owner-occupied commercial real estate retail . . . . . . . . . . . . . . Non Owner-occupied commercial real estate office buildings . . . . . Non owner occupied commercial real estate other(1). . . . . . . . . . . . . Warehouses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gas station/Convenience store. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mobile Home Parks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 86,307 9,031 20,262 19,851 9,057 14,202 64,590 12,818 8,835 7,691 34.1% $ 62,879 7,273 3.6 21,189 8.0 20,972 7.9 10,248 3.6 11,732 5.6 40,908 25.6 17,678 5.1 9,469 3.5 8,921 3.0 29.8% 3.4 10.0 9.9 4.9 5.5 19.4 8.4 4.5 4.2 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $252,644 100.0% $211,269 100.0% (1) Other commercial real estate loans includes schools, churches, storage facilities, restaurants, etc. Construction and Land Lending. We originate construction loans secured by single-family residences and commercial and multifamily real estate. We also originate land acquisition and development loans, which are secured by raw land or developed lots on which the borrower intends to build a residence. At December 31, 2018, our construction and land loans totaled $65.3 million, or 10.6% of our total loan portfolio, compared to $61.5 million, or 11.2 % of our total loan portfolio at December 31, 2017. At December 31, 2018, unfunded construction loan commitments totaled $60.6 million. Construction loans to individuals and contractors for the construction of personal residences, including speculative residential construction, totaled $23.5 million, or 36.1 %, of our construction and land portfolio at December 31, 2018. In addition to custom home construction loans to individuals, we originate loans that are termed ‘‘speculative’’ which are those loans where the builder does not have, at the time of loan origination, a signed contract with a buyer for the home or lot who has a commitment for permanent financing with either us or another lender. At December 31, 2018, construction loans to contractors for homes that were considered speculative totaled $13.2 million, or 20.3 %, of our construction and land portfolio. The composition of, and location of underlying collateral securing, our construction and land loan portfolio, excluding loan commitments, at December 31, 2018 was as follows (in thousands): Commercial and multifamily construction . . . . . . . . . . . . . . . . . . . . . Speculative residential construction . . . . . . . . . . . . . . . . . . . . . . . . . . Land acquisition and development and lot loans . . . . . . . . . . . . . . . . Residential lot loans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Residential construction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Puget Sound $25,250 13,154 6,500 449 9,110 Olympic Peninsula Other Total $ — $5,183 — 1,548 — 12 94 3,250 — 709 $30,433 13,248 11,298 449 9,831 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $54,463 $4,053 $6,743 $65,259 Our residential construction loans generally provide for the payment of interest only during the construction phase, which is typically twelve to eighteen months. At the end of the construction phase, the construction loan generally either converts to a longer term mortgage loan or is paid off with a permanent loan from another lender. Residential construction loans are made up to the lesser of a maximum loan-to-value ratio of 100% of cost or 80% of appraised value at completion; however, we generally do not originate construction loans which exceed these limits without some form of credit enhancement to mitigate the higher loan to value. At December 31, 2018, our largest residential construction loan commitment was for $4.2 million, $3.8 million of which had been disbursed. This loan was performing according to its repayment terms at December 31, 2018. The average outstanding residential construction loan balance was approximately $445,000 at December 31, 2018. Before making a commitment to fund a construction loan, we require an appraisal of the subject property 12 by an independent approved appraiser. During the construction phase, we make periodic inspections of the construction site and loan proceeds are disbursed directly to the contractors or borrowers as construction progresses. Loan proceeds are disbursed after inspection based on the percentage of completion method. We also require general liability, builder’s risk hazard insurance, title insurance, and flood insurance, for properties located in or to be built in a designated flood hazard area, on all construction loans. We also originate developed lot and raw land loans to individuals intending to construct a residence in the future on the property. We will generally originate these loans in an amount up to 75% of the lower of the purchase price or appraisal. These lot and land loans are secured by a first lien on the property and have a fixed rate of interest with a maximum amortization of 20 years. We make land acquisition and development loans to experienced builders or residential lot developers in our market area. The maximum loan-to-value limit applicable to these loans is generally 75% of the appraised market value upon completion of the project. We may not require cash equity from the borrower if there is sufficient equity in the land being used as collateral. Development plans are required prior to making the loan. Our loan officers visit the proposed site of the development and the sites of competing developments. We require that developers maintain adequate insurance coverage. Land acquisition and development loans generally are originated with a loan term up to 24 months, have adjustable rates of interest based on the Wall Street Journal Prime Rate or the three or five- year rate charged by the Federal Home Loan Bank of Des Moines (‘‘FHLB’’) and require interest only payment during the term of the loan. Land acquisition and development loan proceeds are disbursed periodically in increments as construction progresses and as an inspection by our approved inspector warrants. We also require these loans to be paid on an accelerated basis as the lots are sold, so that we are repaid before all the lots are sold. At December 31, 2018, land acquisition and development and lot loans totaled $11.3 million, or 17.3% of our construction and land portfolio all of which were lot loans. We also offer commercial and multifamily construction loans. These loans are underwritten as interest only with financing typically up to 24 months under terms similar to our residential construction loans. Commercial and multifamily construction loans are made up to the lesser of a maximum loan-to-value ratio of 100% of cost or 80% of appraised value at completion. Most of our commercial and multifamily construction loans provide for disbursement of loan funds during the construction period and conversion to a permanent loan when the construction is complete, and either tenant lease-up provisions or prescribed debt service coverage ratios are met. At December 31, 2018, commercial and multifamily construction loans totaled $30.4 million, or 46.6% of our construction and land portfolio, compared to $19.5 million, or 31.8% of our construction and land portfolio at December 31, 2017. The three largest commercial and multifamily construction loans at December 31, 2018 included a $6.5 million loan secured by a multifamily residential building, a $5.3 million loan secured by a multifamily residential and mixed use project and a $4.4 million loans secured by a multifamily residential and retail building, all located in Washington. Our construction and land development loans are based upon estimates of costs in relation to values associated with the completed project. Construction/land lending involves additional risks when compared with permanent residential lending because funds are advanced upon the collateral for the project based on an estimate of costs that will produce a future value at completion. Because of the uncertainties inherent in estimating construction costs, as well as the market value of the completed project and the effects of governmental regulation on real property, it is relatively difficult to evaluate accurately the total funds required to complete a project and the completed project loan-to-value ratio. Changes in the demand, such as for new housing and higher than anticipated building costs may cause actual results to vary significantly from those estimated. For these reasons, this type of lending also typically involves higher loan principal amounts and is often concentrated with a small number of builders. A downturn in housing, or the real estate market, could increase loan delinquencies, defaults and foreclosures, and significantly impair the value of our collateral and our ability to sell the collateral upon foreclosure. Some of our builders have more than one loan outstanding with us and also have residential mortgage loans for rental properties with us. Consequently, an adverse development with respect to one loan or one credit relationship can expose us to a significantly greater risk of loss. In addition, during the term of most of our construction loans, no payment from the borrower is required since the accumulated interest is added to the principal of the loan through an interest reserve. As a result, these loans often involve the disbursement of funds with repayment substantially dependent on the success of the ultimate project and the ability of the borrower to sell or lease the property or obtain permanent take-out financing, rather than the ability of the borrower or guarantor to repay principal and interest. If our appraisal of the value of a 13 completed project proves to be overstated, we may have inadequate security for the repayment of the loan upon completion of construction of the project and may incur a loss. Because construction loans require active monitoring of the building process, including cost comparisons and on-site inspections, these loans are more difficult and costly to monitor. Increases in market rates of interest may have a more pronounced effect on construction loans by rapidly increasing the end purchasers’ borrowing costs, thereby reducing the overall demand for the project. Properties under construction may be difficult to sell and typically must be completed in order to be successfully sold which also complicates the process of resolving problem construction loans. This may require us to advance additional funds and/or contract with another builder to complete construction. Furthermore, in the case of speculative construction loans, there is the added risk associated with identifying an end-purchaser for the finished project. Land loans also pose additional risk because of the lack of income being produced by the property and the potential illiquid nature of the collateral. These risks can also be significantly impacted by supply and demand conditions. A downturn in housing, or the real estate market, could increase loan delinquencies, defaults and foreclosures, and significantly impair the value of our collateral and our ability to sell the collateral upon foreclosure. Commercial Business Lending. At December 31, 2018, commercial business loans totaled $38.8 million, or 6.2% of our total loan portfolio, compared to $40.8 million, or 7.4% of our total loan portfolio at December 31, 2017. Substantially all of our commercial business loans have been to borrowers in our market area. Our commercial business lending activities encompass loans with a variety of purposes and security, including loans to finance commercial vehicles and equipment and loans secured by accounts receivable and/or inventory. Approximately $1.1 million of our commercial business loans at December 31, 2018 were unsecured. Our commercial business lending policy includes an analysis of the borrower’s background, capacity to repay the loan, the adequacy of the borrower’s capital and collateral, as well as an evaluation of other conditions affecting the borrower. Analysis of the borrower’s past, present and future cash flows is also an important aspect of our credit analysis. We generally require personal guarantees on both our secured and unsecured commercial business loans. Nonetheless, commercial business loans are believed to carry higher credit risk than residential mortgage and commercial real estate loans. Our interest rates on commercial business loans are dependent on the type of loan. Our secured commercial business loans typically have a loan to value ratio of up to 80% and are term loans ranging from three to seven years. Secured commercial business term loans generally have a fixed rated based on the commensurate FHLB amortizing rate or prime rate as reported in the West Coast edition of the Wall Street Journal plus 1% to 3%. In addition, we typically charge loan fees of 1% to 2% of the principal amount at origination, depending on the credit quality and account relationships of the borrower. Business lines of credit are usually adjustable-rate and are based on the prime rate plus 1% to 3%, and are generally originated with both a floor and ceiling to the interest rate. Our business lines of credit generally have terms ranging from 12 months to 24 months and provide for interest-only monthly payments during the term. Our commercial business loans are primarily based on the cash flow of the borrower and secondarily on the underlying collateral provided by the borrower. The borrowers’ cash flow may be unpredictable, and collateral securing these loans may fluctuate in value. This collateral may consist of accounts receivable, inventory, equipment or real estate. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers. Other collateral securing loans may depreciate over time, may be difficult to appraise, may be illiquid and may fluctuate in value based on the specific type of business and equipment. As a result, the availability of funds for the repayment of commercial business loans may be substantially dependent on the success of the business itself which, in turn, is often dependent in part upon general economic conditions. Consumer Lending. We offer a variety of secured and unsecured consumer loans, including new and used manufactured homes, floating homes, automobiles, boats and recreational vehicle loans, and loans secured by deposit accounts. We also offer unsecured consumer loans. We originate our consumer loans primarily in our market area. All of our consumer loans are originated on a direct basis. At December 31, 2018, our consumer loans totaled $67.6 million, or 10.9% of our total loan portfolio, compared to $51.1 million, or 9.3 % of our total loan portfolio at December 31, 2017. We typically originate new and used manufactured home loans to borrowers who intend to use the home as a primary residence. The yields on these loans are higher than that on our other residential lending products and the portfolio has performed reasonably well with an acceptable level of risk and loss in exchange for the higher 14 yield. Our weighted-average yield on manufactured home loans at December 31, 2018 was 8.13 %, compared to 4.69 % for one- to four-family mortgages, excluding loans held-for-sale. At December 31, 2018, these loans totaled $20.1 million, or 29.8 % of our consumer loans and 3.2 % of our total loan portfolio. For used manufactured homes, loans are generally made up to 90% of the lesser of the appraised value or purchase price up to $200,000, and with terms typically up to 20 years. On new manufactured homes, loans are generally made up to 90% of the lesser of the appraised value or purchase price up to $200,000, and with terms typically up to 20 years. We generally charge a 1% fee at origination. We underwrite these loans based on our review of creditworthiness of the borrower, including credit scores, and the value of the collateral, for which we hold a security interest under Washington law. Manufactured home loans are higher risk than loans secured by residential real property, though this risk is reduced if the owner also owns the land on which the home is located. A small portion of our manufactured home loans involve properties on which we also have financed the land for the owner. The primary risk in manufactured home loans is the difficulty in obtaining adequate value for the collateral due to the cost and limited ability to move the collateral. These loans tend to be made to retired individuals and first-time homebuyers. First-time homebuyers of manufactured homes tend to be a higher credit risk than first-time homebuyers of single-family residences, due to more limited financial resources. As a result, these loans may have a higher probability of default and higher delinquency rates than single-family residential loans and other types of consumer loans. We take into account this additional risk as a component of our allowance for loan losses. We attempt to work out delinquent loans with the borrower and, if that is not successful, any past due manufactured homes are repossessed and sold. At December 31, 2018, there were eight nonperforming manufactured home loans totaling $214,000. We originate floating home, houseboat and house barge loans typically located on cooperative or condominium moorages. Terms vary from five to 20 years and have a fixed rate of interest. We lend up to 90% of the lesser of the appraised value or purchase price. The primary risk in floating home loans is the unique nature of the collateral and the challenges of relocating such collateral to a location other than where such housing is permitted. The process for securing the deed and/or the condominium or cooperative dock is also unique compared to other types of lending we participate in. As a result, these loans may have higher collateral recovery costs than for one- to four-family mortgage loans and other types of consumer loans. We take into account these additional risks as a part of our underwriting criteria. At December 31, 2018, floating home loans totaled $40.8 million, or 60.4 % of our consumer loan portfolio and 6.6% of our total loan portfolio. The balance of our consumer loans include loans secured by new and used automobiles, new and used boats, motorcycles and recreational vehicles, loans secured by deposits and unsecured consumer loans, all of which, at December 31, 2018, totaled $6.6 million, or 9.8 % of our consumer loan portfolio and 1.1 % of our total loan portfolio. Our automobile loan portfolio totaled $684,000 at December 31, 2018, or 1.0 % of our consumer loan portfolio and 0.1 % of our total loan portfolio. Automobile loans may be written for a term up to 72 months and have fixed rates of interest. Loan-to-value ratios are up to 100% of the lesser of the purchase price or the National Automobile Dealers Association value for used automobiles, including tax, licenses, title and mechanical breakdown and gap insurance. Loans secured by boats, motorcycles and recreational vehicles typically have terms from five to 20 years depending on the collateral and loan-to-value ratios up to 90%. These loans may be made with fixed or adjustable interest rates. Our unsecured consumer loans have either a fixed rate of interest generally for a maximum term of 48 months, or are revolving lines of credit of generally up to $25,000. At December 31, 2018, unsecured consumer loans totaled $1.0 million and unfunded commitments on our unsecured consumer lines of credit totaled $1.1 million. At that date, the average outstanding balance on these lines was less than $1,000. Consumer loans (other than our manufactured and floating homes) generally have shorter terms to maturity, which reduces our exposure to changes in interest rates. In addition, management believes that offering consumer loan products helps to expand and create stronger ties to our existing client base by increasing the number of client relationships and providing additional marketing opportunities. Consumer loans generally entail greater risk than do one- to four-family residential mortgage loans, particularly in the case of consumer loans that are secured by rapidly depreciable assets, such as manufactured homes, automobiles, boats and recreational vehicles. In these cases, any repossessed collateral for a defaulted loan may 15 not provide an adequate source of repayment of the outstanding loan balance. As a result, consumer loan collections are dependent on the borrower’s continuing financial stability and, thus, are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Loan Originations, Purchases, Sales, Repayments and Servicing We originate both fixed-rate and adjustable-rate loans. Our ability to originate loans, however, is dependent upon client demand for loans in our market area. Over the past several years, we have continued to originate residential and consumer loans, and increased our emphasis on commercial and multifamily real estate, construction and land, and commercial business lending. Demand is affected by competition and the interest rate environment. During the past few years, we, like many other financial institutions, have experienced significant prepayments on loans due to the prevailing low interest rate environment in the United States. In periods of economic uncertainty, the ability of financial institutions, including us, to originate large dollar volumes of real estate loans may be substantially reduced or restricted, with a resultant decrease in interest income. If a proposed loan exceeds our internal lending limits, we may originate the loan on a participation basis with another financial institution. From time to time, we also participate with other financial institutions on loans they originate. We did not sell commercial loan participations to other financial institutions in 2018. In 2017 and 2016, we sold commercial loan participations in the amount of $3.1 million and $3.0 million, respectively. We underwrite loan purchases and participations to the same standards as an internally-originated loan. We had no purchases of commercial business loan participations from other financial institutions in 2018. We purchased two commercial business loan participations from other financial institutions totaling $15.5 million in 2017 and $2.7 million in 2016. We do not engage in originating negative amortization or option adjustable rate loans and have no established program to originate or purchase these loans. We do offer interest-only one- to four-family loans to well-qualified borrowers and at December 31, 2018, we held $10.2 million of such loans in our loan portfolio, representing 1.6 % of our total loan portfolio. Subprime loans are defined by the FDIC as loans that at the time of loan origination had a FICO credit score of 660 or lower. Of the $112.5 million in one- to four-family loans originated in 2018, only $8.9 million, or 7.9 %, were to borrowers with a credit score under 660. Additionally, of the $7.3 million in manufactured home loans originated in 2018, $813,000, or 11.1% were to borrowers with a credit score under 660. As of December 31, 2018 and 2017, the total amount of loans held in our loan portfolio to borrowers with a FICO score of 660 or lower were $27.5 million and $29.9 million, respectively. In exchange for the additional lender risk associated with these loans, these borrowers may be required to pay a higher interest rate, and depending on the severity of the credit history, a lower loan-to-value ratio may be required than for a conforming loan borrower. The repayment performance of these loans has been substantially the same as other loans in these portfolios. In addition to interest earned on loans and loan origination fees, we receive fees for loan commitments, late payments and other miscellaneous services. We also sell whole one- to four-family loans without recourse to Fannie Mae, subject to a provision for repurchase upon breach of representation, warranty or covenant. These loans are fixed-rate mortgages, which primarily are sold to reduce our interest rate risk and generate noninterest income. These loans are generally sold for cash in amounts equal to the unpaid principal amount of the loans determined using present value yields to the buyer. These sales allow for a servicing fee on loans when the servicing is retained by us. Most one- to four-family loans are sold with servicing retained. At December 31, 2018, we were servicing a $352.2 million portfolio of residential mortgage loans for Fannie Mae. We did not repurchase any loans in 2018 and repurchased one loan in 2017 totaling $135,000. We earned mortgage servicing income of $562,000, $566,000 and $907,000 for the years ended December 31, 2018, 2017 and 2016, respectively. In November 2009, we acquired a $340.1 million loan servicing portfolio from Leader Financial Services. These loans are 100% owned by Fannie Mae and are subserviced under an agreement with a third party loan servicer who performs all servicing including payment processing, reporting and collections. In October 2015, we acquired a $45.9 million loans servicing portfolio from Seattle Bank. These loans are 100% owned by Fannie Mae and are serviced by us. These mortgage servicing rights are carried at fair value and had a value at December 31, 2018 of $3.4 million. See Note 6 in the Notes to Consolidated Financial Statements contained in Item 8 of this report on Form 10-K. 16 Sales of whole real estate loans are beneficial to us since these sales may generate income at the time of sale, produce future servicing income on loans where servicing is retained, provide funds for additional lending, and increase liquidity. We sold $50.0 million, $52.0 million and $85.1 million of conforming one- to four-family loans during the years ended December 31, 2018, 2017 and 2016, respectively. Gains, losses and transfer fees on sales of one- to four-family loans and participations are recognized at the time of the sale. Our net gain on sales of residential loans for the years ended December 31, 2018, 2017 and 2016 was $1.3 million, $1.1 million and $1.4 million, respectively. In addition to loans sold to Fannie Mae on a servicing retained basis, we also sell nonconforming residential loans to correspondent banks on a servicing released basis. In 2018 and 2017, we sold $7.6 million and $4.3 million, respectively, of loans servicing released. The following table shows our loan origination, sale and repayment activities, including loans held-for-sale, for the periods indicated (in thousands): Originations by type: Fixed-rate: One-to-four family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Home equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial and multifamily . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Construction and land. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Manufactured homes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Floating homes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other consumer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total fixed-rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjustable rate: One-to-four family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Home equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial and multifamily . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Construction and land. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other consumer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total adjustable-rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total loans originated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchases by type: Commercial business participations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total loan participations purchased . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Sales, repayments and participations sold: One-to-four family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial and multifamily . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total loans sold and loan participations . . . . . . . . . . . . . . . . . . . . . . . Total principal repayments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total reductions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Year Ended December 31, 2017 2016 2018 $ 67,823 4,459 94,725 24,303 7,313 20,660 3,402 2,277 $224,962 44,726 9,705 55,945 — 48 17,202 $ 73,560 4,538 34,438 49,771 5,106 7,409 2,360 10,440 $187,622 36,130 5,832 33,155 6,094 86 7,527 $137,760 1,733 20,561 31,610 5,006 12,694 630 6,365 $216,359 4,970 2,067 37,256 629 81 2,131 $127,626 $352,588 $ 88,824 $276,446 $ 47,134 $263,493 — — 15,450 2,694 $ 15,450 $ 2,694 49,966 — 49,966 231,627 281,593 51,959 3,136 55,095 188,121 243,216 85,092 3,042 88,134 137,400 225,534 Net increase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 70,995 $ 48,680 $ 40,653 The increase in originations in 2018 compared to 2017 was primarily due to the relatively strong economy in our market area and increased sales efforts by our loan officers. Demand for construction loans for new homes and apartments continued to be strong as our markets experienced appreciation in residential market prices and a declining supply of homes for sale because of strong demand. Commercial and multifamily, and floating home loan originations more than doubled in 2018 compared to 2017. Manufactured homes and home equity loan originations also increased significantly in 2018 compared to 2017. One-to-four family fixed rate, residential loan 17 originations decreased while one- to four-family adjustable rate, residential loan originations increased significantly compared to prior years, reflecting the rise in residential mortgage rates over the last year. During 2018, the Bank identified continued demand in the marketplace for one- to-four family adjustable rate, residential mortgages, especially those above the Fannie Mae conforming limits. Commercial business loan originations also increased in 2018 as compared to 2017 as a result of our emphasis on this business segment and the continued demand in our local market. Construction and land loan originations for both fixed rate and adjustable rate loans decreased significantly in 2018 compared to 2017 as we shifted our focus to commercial and multifamily loans originations in 2018. Asset Quality When a borrower fails to make a required payment on a one- to four-family loan, we attempt to cure the delinquency by contacting the borrower. In the case of loans secured by a one- to four-family property, a late notice typically is sent 15 days after the due date. Generally, a pre-foreclosure loss mitigation letter is also mailed to the borrower 30 days after the due date. All delinquent accounts are reviewed by a loan officer or branch manager who attempts to cure the delinquency by contacting the borrower. If the account becomes 120 days delinquent and an acceptable foreclosure alternative has not been agreed upon, we generally refer the account to legal counsel with instructions to prepare a notice of default. The notice of default begins the foreclosure process. If foreclosure is completed, typically we take title to the property and sell it directly through a real estate broker. Delinquent consumer loans are handled in a similar manner to one- to four-family loans. Our procedures for repossession and sale of consumer collateral are subject to various requirements under the applicable consumer protection laws as well as other applicable laws and the determination by us that it would be beneficial from a cost basis. Once a loan is 90 days past due, it is classified as nonaccrual. Generally, delinquent consumer loans are charged-off at 120 days past due, unless we have a reasonable basis to justify additional collection and recovery efforts. Delinquent Loans. The following table sets forth our loan delinquencies by type, by amount and by percentage of type at December 31, 2018 (dollars in thousands): Loans Delinquent For: 30-89 Days 90 Days and Over Total Delinquent Loans Percent of Loan Percent of Loan Number Amount Category Number Amount Category Number Amount Percent of Loan Category One- to four- family . . . . . Home equity . . . . . . . . . . . Commercial and 14 6 $1,529 447 0.9% 1.6 1 Multifamily . . . . . . . . . . 3 Construction and land. . . . Manufactured homes . . . . 8 Floating homes . . . . . . . . . — 12 Other consumer. . . . . . . . . 3 Commercial Business . . . . 139 650 207 — 16 405 0.1 1.0 1.0 — 0.2 1.0 Total. . . . . . . . . . . . . . . . . . 47 $3,393 0.6% 6 7 1 1 6 — — 3 24 $ 514 284 0.3% 1.0 353 50 199 — — 122 0.1 0.1 1.0 — — 0.3 $1,522 0.2% 20 13 2 4 14 — 12 6 71 $2,043 731 1.2% 2.6 492 700 406 — 16 527 0.2 1.1 2.0 — 0.2 1.4 $4,915 0.8% 18 Nonperforming Assets. The table below sets forth the amounts and categories of nonperforming assets in our loan portfolio (in thousands). Loans are placed on nonaccrual status when the collection of principal and/or interest become doubtful or when the loan is more than 90 days past due. Other real estate owned (‘‘OREO’’) and repossessed assets include assets acquired in settlement of loans. 2018 2017 December 31, 2016 2015 2014 Nonperforming loans(1): One- to four-family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Home equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial and multifamily . . . . . . . . . . . . . . . . . . . . . . . . Construction and land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Manufactured homes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total nonperforming loans . . . . . . . . . . . . . . . . . . . . . . . . OREO and repossessed assets: One- to four-family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial and multifamily . . . . . . . . . . . . . . . . . . . . . . . . Manufactured homes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,120 359 534 123 214 — 317 $2,667 $ 837 722 201 92 206 8 217 $2,283 $2,216 553 218 — 120 — 242 $3,349 $ — $ — $ 562 600 10 600 10 575 — Total OREO and repossessed assets . . . . . . . . . . . . . . . . . Total nonperforming assets . . . . . . . . . . . . . . . . . . . . . . $ 575 $3,242 $ 610 $2,893 $1,172 $4,521 $1,640 428 — — 62 — — $2,130 $ 159 600 10 $ 769 $2,899 $1,512 386 1,639 81 195 29 — $3,842 $ 269 — 54 $ 323 $4,165 Nonperforming assets as a percentage of total assets . . . . . 0.45% 0.45% 0.77% 0.54% 0.84% Performing restructured loans: One- to four- family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Home equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial and multifamily . . . . . . . . . . . . . . . . . . . . . . . . Construction and land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Manufactured homes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total performing restructured loans . . . . . . . . . . . . . . . . . $1,511 60 — 44 130 131 97 $1,973 $2,876 158 — 49 150 36 — $3,269 $1,977 144 361 83 160 40 — $2,765 $2,415 232 1,966 91 255 — 114 $5,073 $2,619 679 1,317 99 279 1 123 $5,117 (1) Nonperforming loans include $817,000, $445,000, $683,000, $971,000 and $2.3 million in nonperforming troubled debt restructurings as of December 31, 2018, 2017, 2016, 2015 and 2014, respectively. We had no accruing loan 90 days or more delinquent for the periods reported. Nonperforming loans, consisting of nonaccrual loans and nonperforming TDRs, increased $384,000 to $2.7 million at December 31, 2018 from $2.3 million at December 31, 2017 due primarily to a $283,000 increase in the one- to four-family loan and $333,000 increase in the commercial and multifamily loan categories, partially offset by a $363,000 decrease in the home equity loan category. Our largest nonperforming loan at December 31, 2018 was a $167,000 one- to four-family loan. Nonperforming one- to four-family loans at December 31, 2018 consisted of thirteen loans to different borrowers with an average loan balance of $90,000. There were ten home equity loans, eight manufactured home loans, five commercial business loans, three construction and land loans and two commercial real estate loans classified as nonperforming at December 31, 2018. For the year ended December 31, 2018, gross interest income that would have been recorded had the nonaccrual loans been current in accordance with their original terms amounted to $172,000, all of which was excluded 19 from interest income for the year ended December 31, 2018. See ‘‘Management’s Discussion and Analysis of Financial Condition and Results of Operations — Financial Condition at December 31, 2018 Compared to December 31, 2017 — Delinquencies and Nonperforming Assets’’ contained in Item 7 of this report on Form 10-K for more information on troubled assets. Troubled Debt Restructured Loans. Troubled debt restructurings (‘‘TDRs’’), which are accounted for under ASC 310-40, are loans which have renegotiated loan terms to assist borrowers who are unable to meet the original terms of their loans. Such modifications to loan terms may include a lower interest rate, a reduction in principal, or a longer term to maturity. All TDRs are initially classified as impaired regardless of whether the loan was performing at the time it was restructured. Once a troubled debt restructuring has performed according to its modified terms for six months and the collection of principal and interest under the revised terms is deemed probable, we remove the TDR from nonperforming status. At December 31, 2018, we had $2.0 million of loans that were classified as performing TDRs and still on accrual, compared to $3.3 million at December 31, 2017. Included in nonperforming loans at December 31, 2018 and 2017 were TDRs of $817,000 and $445,000, respectively. OREO and Repossessed Assets. OREO and repossessed assets include assets acquired in settlement of loans. At December 31, 2018, OREO and repossessed assets totaled $575,000. Our OREO at December 31, 2018, consisted 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. The former bank branch property originally was classified as a fixed asset and was subsequently reclassified to OREO in 2016. It is currently leased to a local not-for-profit organization at a below market rate. Other Loans of Concern. In addition to the nonperforming assets set forth in the table above, as of December 31, 2018, there were 34 loans totaling $8.5 million about which known information of possible credit problems caused management to have doubts as to the ability of the borrowers to comply with present loan repayment terms and which may result in the future inclusion of such items in the nonperforming asset categories. The two largest loans of concern at December 31, 2018, were a $2.4 million loan and $2.1 million loan both secured by one- to four-family residential real estate located in King County, Washington. Additional other loans of concern included, $1.6 million in commercial and multifamily real estate loans, $1.6 million in commercial business loans, $571,000 in one-to four-family, $146,000 in home equity loans, $71,000 in manufactured homes, and $52,000 in other consumer loans. Classified Assets. Federal regulations provide for the classification of lower quality loans and other assets (such as OREO and repossessed assets), debt and equity securities considered as ‘‘substandard,’’ ‘‘doubtful’’ or ‘‘loss.’’ An asset is considered ‘‘substandard’’ if it is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. ‘‘Substandard’’ assets include those characterized by the ‘‘distinct possibility’’ that the insured institution will sustain ‘‘some loss’’ if the deficiencies are not corrected. Assets classified as ‘‘doubtful’’ have all of the weaknesses in those classified ‘‘substandard,’’ with the added characteristic that the weaknesses present make ‘‘collection or liquidation in full,’’ on the basis of currently existing facts, conditions and values, ‘‘highly questionable and improbable.’’ Assets classified as ‘‘loss’’ are those considered ‘‘uncollectible’’ and of such little value that their continuance as assets without the establishment of a specific loss reserve is not warranted. When we classify problem assets as either substandard or doubtful, we may establish a specific allowance in an amount we deem prudent to address specific impairments. General allowances represent loss allowances which have been established to recognize the inherent risk associated with lending activities, but which, unlike specific allowances, have not been specifically allocated to particular problem assets. When an insured institution classifies problem assets as a loss, it is required to charge off those assets in the period in which they are deemed uncollectible. Our determination as to the classification of our assets and the amount of our valuation allowances is subject to review by the FDIC and, since our conversion to a Washington chartered commercial bank, the WDFI, which can order the establishment of additional loss allowances. Assets which do not currently expose us to sufficient risk to warrant classification in one of the aforementioned categories but possess weaknesses are required to be designated as special mention. At December 31, 2018, special mention assets totaled $6.1 million. We regularly review the problem assets in our portfolio to determine whether any assets require classification in accordance with applicable regulations. On the basis of management’s review of our assets, at December 31, 20 2018, we had classified $11.7 million of our assets as substandard, of which $11.1 million represented a variety of outstanding loans and $575,000 represented the balance of our OREO and repossessed assets. At that date, we had no assets classified as doubtful or loss. This total amount of classified assets represented 16.3% of our equity capital and 1.6% of our assets at December 31, 2018. Classified assets totaled $6.8 million, or 10.4% of our equity capital and 1.1% of our assets at December 31, 2017. Allowance for Loan Losses. We maintain an allowance for loan losses to absorb probable loan losses in the loan portfolio. The allowance is based on ongoing, monthly assessments of the estimated probable incurred losses in the loan portfolio. In evaluating the level of the allowance for loan losses, management considers the types of loans and the amount of loans in the loan portfolio, peer group information, historical loss experience, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, and prevailing economic conditions. Large groups of smaller balance homogeneous loans, such as one- to four-family, small commercial and multifamily real estate, home equity and consumer loans, including floating homes and manufactured homes, are evaluated in the aggregate using historical loss factors and peer group data adjusted for current economic conditions. More complex loans, such as commercial and multifamily real estate loans and commercial business loans are evaluated individually for impairment, primarily through the evaluation of the borrower’s net operating income and available cash flow and their possible impact on collateral values. At December 31, 2018, our allowance for loan losses was $5.8 million, or 0.93% of our total loan portfolio, compared to $5.2 million, or 0.96% of our total loan portfolio in 2017. Specific valuation reserves totaled $736,000 and $1.1 million at December 31, 2018 and 2017, respectively. Assessing the allowance for loan losses is inherently subjective as it requires making material estimates, including the amount and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change. In the opinion of management, the allowance, when taken as a whole, properly reflects estimated probable loan losses inherent in our loan portfolio. See Notes 1 and 5 in the Notes to Consolidated Financial Statements contained in Item 8 of this report on Form 10-K. The following table sets forth an analysis of our allowance for loan losses at the dates indicated (dollars in thousands): Balance at beginning of period . . . . . . . . . . . . . . . . . . . . Charge-offs: One- to four-family. . . . . . . . . . . . . . . . . . . . . . . . . . . . Home equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial and multifamily . . . . . . . . . . . . . . . . . . . . Construction and land. . . . . . . . . . . . . . . . . . . . . . . . . . Manufactured homes . . . . . . . . . . . . . . . . . . . . . . . . . . Other consumer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business . . . . . . . . . . . . . . . . . . . . . . . . . . Total charge-offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Recoveries: One- to four-family. . . . . . . . . . . . . . . . . . . . . . . . . . . . Home equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial and multifamily . . . . . . . . . . . . . . . . . . . . Construction and land. . . . . . . . . . . . . . . . . . . . . . . . . . Manufactured homes . . . . . . . . . . . . . . . . . . . . . . . . . . Other consumer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business . . . . . . . . . . . . . . . . . . . . . . . . . . Total recoveries. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net recoveries (charge-offs) . . . . . . . . . . . . . . . . . . . . . Provisions charged to operations . . . . . . . . . . . . . . . . . Balance at end of period . . . . . . . . . . . . . . . . . . . . . . . . . Net recoveries (charge-offs) during the period as a percentage of average loans outstanding during the period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2018 $5,241 2017 $4,822 December 31, 2016 $4,636 2015 $4,387 2014 $4,177 — (7) — — (12) (31) — (50) 1 44 — — — 12 1 58 8 525 $5,774 — (89) (24) — (12) (18) — (143) — 33 1 — 8 20 — 62 (81) 500 $5,241 (72) (15) (314) — — (42) (29) (472) 47 78 — 18 8 53 — 204 (268) 454 $4,822 (21) (35) — (40) (37) (77) — (210) — 36 — — 8 15 — 59 (151) 400 $4,636 (127) (295) (47) — (197) (77) — (743) 64 52 2 — 14 21 — 153 (590) 800 $4,387 —% (0.02)% (0.06)% (0.03)% (0.14)% 21 Net recoveries (charge-offs) during the period as a percentage of average nonperforming assets . . . . . . . . Allowance as a percentage of nonperforming loans . . . . Allowance as a percentage of total loans (end of 2018 2017 December 31, 2016 2015 2014 0.30% (2.12)% (6.27)% (5.26)% (18.65)% 216.50% 229.57% 143.98% 217.65% 114.19% period) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.93% 0.96% 0.96% 1.01% 1.02% Economic conditions have been favorable in our market areas. Housing prices have experienced continued growth throughout 2018, with historically low inventory levels. Unemployment rates in many of our market areas remain low as the job market is competitive. The decrease in our allowance for loan losses as a percentage of nonperforming loans during 2018 was primarily a result of loan growth. The allowance for loan losses as a percentage of nonperforming loans was 216.50% and 229.57% as of December 31, 2018 and 2017, respectively. The unallocated portion of our allowance for loan losses has increased in 2018 primarily due to an increase in amount of loan losses, loan recoveries and impaired loans relative to prior periods. The provision for loan losses totaled $525,000 for the year ended December 31, 2018, compared to $500,000 for the year ended December 31, 2017. The increase was primarily as a result of the increase in loans held for portfolio and to a lesser extent the increase in non-performing loans as compared to December 31, 2017. The distribution of our allowance for losses on loans at the dates indicated is summarized as follows (dollars in thousands): 2018 2017 December 31, 2016 2015 2014 Percent of loans in each category to total loans Percent of loans in each category to total loans Amount Amount Percent of loans in each category to total loans Amount Percent of loans in each category to total loans Amount Percent of loans in each category to total loans Amount Allocated at end of period to: One- to four-family . . . . $1,314 202 Home equity . . . . . . . . . Commercial and multifamily . . . . . . . . Construction and land . . Manufactured homes . . . Floating homes . . . . . . . Other consumer . . . . . . . Commercial business . . . Unallocated . . . . . . . . . . 1,638 431 427 265 112 356 1,029 27.3% $1,436 293 4.4 28.5% $1,542 378 5.2 30.3% $1,839 607 5.5 30.5% $1,442 601 6.9 30.9% 8.0 40.6 10.6 3.2 6.6 1.1 6.2 — 1,250 378 355 169 80 372 908 38.4 11.2 3.1 5.3 0.9 7.4 — 1,144 459 168 132 112 175 712 36.1 14.1 3.1 4.8 0.8 5.3 — 921 382 301 102 86 157 241 38.0 12.4 3.0 4.0 1.0 4.2 — 1,244 399 193 90 77 108 233 39.1 10.7 2.9 2.7 1.2 4.5 — Total . . . . . . . . . . . . . $5,774 100.0% $5,241 100.0% $4,822 100.0% $4,636 100.0% $4,387 100.0% Investment Activities State chartered commercial banks have the authority to invest in various types of liquid assets, including United States Treasury obligations, securities of various federal agencies, including callable agency securities, certain certificates of deposit of insured commercial banks and savings banks, certain bankers’ acceptances, repurchase agreements and federal funds. Subject to various restrictions, state commercial banks may also invest their assets in investment grade commercial paper and corporate debt securities and mutual funds whose assets conform to the investments that the institution is otherwise authorized to make directly. See ‘‘— How We Are Regulated — Sound Community Bank’’ for a discussion of additional restrictions on our investment activities. Our Chief Executive Officer and Chief Financial Officer have the responsibility for the management of our investment portfolio, subject to the direction and guidance of the Board of Directors. These officers consider various factors when making decisions, including the marketability, maturity and tax consequences of the 22 proposed investment. The maturity structure of investments will be affected by various market conditions, including the current and anticipated slope of the yield curve, the level of interest rates, the trend of new deposit inflows, and the anticipated demand for funds via deposit withdrawals and loan originations and purchases. The general objectives of our investment portfolio are to provide liquidity when loan demand is high, to assist in maintaining earnings when loan demand is low and to maximize earnings while satisfactorily managing risk, including credit risk, reinvestment risk, liquidity risk and interest rate risk. Our investment quality emphasizes safer investments with the yield on those investments secondary to not taking unnecessary risk with the available funds. See ‘‘Quantitative and Qualitative Disclosures About Market Risk’’ for additional information about our interest rate risk management contained in Item 7A. of this report on Form 10-K. At December 31, 2018, we owned $4.1 million of stock issued by the FHLB. As a condition of membership in the FHLB, we are required to purchase and hold a certain amount of FHLB stock. The following table sets forth the composition of our securities portfolio and other investments at the dates indicated. At December 31, 2018, our securities portfolio did not contain securities of any issuer with an aggregate book value in excess of 10% of our equity capital. See Note 4 in the Notes to Consolidated Financial Statements contained in Item 8 of this report on Form 10-K. Securities available-for-sale 2018 Amortized Cost Municipal bonds. . . . . . . . . . . . . . . . . . . . . Agency mortgage-backed securities . . . . . Non-agency mortgage-backed securities. . Total available for sale securities . . . . . . . FHLB stock . . . . . . . . . . . . . . . . . . . . . . . . $3,218 1,594 — 4,812 4,134 December 31, 2017 Amortized Cost $3,240 2,030 — 5,270 3,065 Fair Value $3,369 2,066 — 5,435 3,065 Fair Value $3,317 1,640 — 4,957 4,134 2016 Amortized Cost $3,262 2,858 362 6,482 2,840 Fair Value $3,353 2,904 347 6,604 2,840 Total securities . . . . . . . . . . . . . . . . . . . . $8,946 $9,091 $8,335 $8,500 $9,322 $9,444 We review investment securities on an ongoing basis for the presence of other-than-temporary impairment (‘‘OTTI’’) taking into consideration current market conditions, fair value in relationship to cost, extent and nature of the change in fair value, issuer rating changes and trends, whether we intend to sell a security or if it is likely that we will be required to sell the security before recovery of our amortized cost basis of the investment, which may be maturity, and other factors. For debt securities, if we intend to sell the security or it is likely that we will be required to sell the security before recovering its cost basis, the entire impairment loss would be recognized in earnings as an OTTI. If we do not intend to sell the security and it is not more likely than not that we will be required to sell the security but we do not expect to recover the entire amortized cost basis of the security, only the portion of the impairment loss representing credit losses would be recognized in earnings. The credit loss on a security is measured as the difference between the amortized cost basis and the present value of the cash flows expected to be collected. Projected cash flows are discounted by the original or current effective interest rate depending on the nature of the security being measured for potential OTTI. The remaining impairment related to all other factors, the difference between the present value of the cash flows expected to be collected and the fair value, is recognized as a charge to other comprehensive income. Impairment losses related to all other factors are presented as separate categories within other comprehensive income. During the year ended December 31, 2018, we did not recognize any non-cash OTTI charges on our investment securities. Three municipal bond securities had unrealized losses although management determined the decline in value was not related to specific credit deterioration. We do not intend to sell these securities and it is more likely than not that we will not be required to sell any securities before anticipated recovery of the remaining amortized cost basis. We closely monitor our investment securities for changes in credit risk. The current market environment significantly limits our ability to mitigate our exposure to valuation changes in these securities by selling them. If market conditions deteriorate and we determine our holdings of these or other investment securities are OTTI, our future earnings, shareholders’ equity, regulatory capital and continuing operations could be materially adversely affected. 23 Sources of Funds General. Our sources of funds are primarily deposits (including deposits from public entities), borrowings, payments of principal and interest on loans and investments and funds provided from operations. Deposits. We offer a variety of deposit accounts to both consumers and businesses with a wide range of interest rates and terms. Our deposits consist of savings accounts, money market deposit accounts, NOW accounts, demand accounts and certificates of deposit. We solicit deposits primarily in our market area; however, at December 31, 2018, approximately 4.2% of our deposits were from persons outside the State of Washington. As of December 31, 2018, core deposits, which we define as our non-time deposit accounts and time deposit accounts less than $250,000, represented approximately 90.5% of total deposits, compared to 90.8% and 88.0% as of December 31, 2017 and December 31, 2016, respectively. We primarily rely on competitive pricing policies, marketing and client service to attract and retain these deposits and we expect to continue these practices in the future. The flow of deposits is influenced significantly by general economic conditions, changes in money market and prevailing interest rates and competition. The variety of deposit accounts we offer has allowed us to be competitive in obtaining funds and to respond with flexibility to changes in consumer demand. We are more susceptible to short-term fluctuations in deposit flows as clients are more interest rate sensitive. We manage the pricing of our deposits in keeping with our asset/liability management, liquidity and profitability objectives, subject to competitive factors. Based on our experience, we believe that our deposits are relatively stable sources of funds. Despite this stability, our ability to attract and maintain these deposits and the rates paid on them is and will continue to be significantly affected by market conditions. The following table sets forth our deposit flows during the periods indicated (dollars in thousands): Opening balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest credited . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ending balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Year Ended December 31, 2017 2016 2018 $514,400 35,362 3,839 $553,601 $467,731 43,648 3,021 $514,400 $440,024 24,999 2,708 $467,731 Net increase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Percent increase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 39,201 $ 46,669 $ 27,707 7.6% 10.0% 6.3% The following table sets forth the dollar amount of deposits in the various types of deposit programs offered by us at the dates indicated (dollars in thousands): 2018 December 31, 2017 2016 Amount Percent of total Amount Percent of total Amount Percent of total Noninterest-bearing demand . . . . . . $ 93,823 164,919 Interest-bearing demand . . . . . . . . . 54,102 Savings . . . . . . . . . . . . . . . . . . . . . . 46,689 Money market . . . . . . . . . . . . . . . . . 2,243 Escrow . . . . . . . . . . . . . . . . . . . . . . . 17.0% $ 69,094 173,413 29.8 49,450 9.8 54,860 8.4 3,029 0.4 13.4% $ 60,566 150,327 33.7 44,879 9.6 49,042 10.7 3,175 0.6 Total non-maturity deposits . . . . . . 361,776 65.4 349,846 68.0 307,989 Certificates of deposit: 1.99% or below . . . . . . . . . . . . . . . . 2.00 - 3.99% . . . . . . . . . . . . . . . . . . 118,478 73,347 Total certificates of deposit. . . . . . . 191,825 21.4 13.2 34.6 154,102 10,452 164,554 30.0 2.0 32.0 152,294 7,448 159,742 12.9% 32.1 9.6 10.5 0.7 65.8 32.6 1.6 34.2 Total deposits . . . . . . . . . . . . . . . . . $553,601 100.0% $514,400 100.0% $467,731 100.0% 24 Noninterest-bearing demand accounts increased 35.8% in 2018 compared to 2017. The increase was primarily a result of our continued emphasis on attracting relatively low-cost core deposit accounts, in particular from small businesses. The increase in certificate accounts over the past year was as a result of our marketing emphasis on our competitively priced certificates of deposits products. We are a public funds depository and as of December 31, 2018, we had $29.0 million in public funds compared to $30.0 million in public funds at December 31, 2017. These funds consisted of $25.7 million in certificates of deposit, $3.2 million in money market accounts and $37,000 in checking accounts at December 31, 2018. These accounts must be 50% collateralized if the amount on deposit exceeds FDIC insurance of $250,000. We use letters of credit from the FHLB as collateral for these funds. The following table shows rate and maturity information for our certificates of deposit at December 31, 2018 (dollars in thousands): 0.00-1.99% 2.00-3.99% Total Percent of Total Certificate accounts maturing in quarter ending: March 30, 2019 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . June 30, 2019 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . September 30, 2019 . . . . . . . . . . . . . . . . . . . . . . . . . . . December 31, 2019 . . . . . . . . . . . . . . . . . . . . . . . . . . . March 30, 2020 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . June 30, 2020 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . September 30, 2020 . . . . . . . . . . . . . . . . . . . . . . . . . . . December 31, 2020 . . . . . . . . . . . . . . . . . . . . . . . . . . . March 30, 2021 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . June 30, 2021 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . September 30, 2021 . . . . . . . . . . . . . . . . . . . . . . . . . . . December 31, 2021 . . . . . . . . . . . . . . . . . . . . . . . . . . . Thereafter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 42,701 26,848 12,899 4,161 4,859 3,278 2,732 1,074 3,407 3,562 6,546 1,655 4,756 $118,478 $ 3,304 3,134 7,730 9,971 4,227 5,636 10,349 20,897 464 394 51 50 7,140 $73,347 $ 46,005 29,982 20,629 14,132 9,086 8,914 13,081 21,971 3,871 3,956 6,597 1,705 11,896 $191,825 24.0% 15.6 10.8 7.4 4.7 4.6 6.8 11.5 2.0 2.1 3.4 0.9 6.2 100.0% Percent of total. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61.8% 38.2% 100.0% The following table indicates the amount of our certificates of deposit and other deposits by time remaining until maturity as of December 31, 2018 (in thousands): Certificates of deposit less than $100,000 . . . . . . . . . Certificates of deposit of $100,000 or more. . . . . . . . 3 months or less $14,790 31,215 Over 3 to 6 months $12,044 17,938 Total certificates of deposit . . . . . . . . . . . . . . . . . . . $46,005 $29,982 Over 6 to 12 months $ 9,884 24,877 $34,761 Over 12 months $29,237 51,840 Total $ 65,955 125,870 $81,077 $191,825 Maturity Borrowings. Although deposits are our primary source of funds, we may utilize borrowings as a cost-effective source of funds when they can be invested at a positive interest rate spread, for additional capacity to fund loan demand, or to meet our asset/liability management goals. Our borrowings currently consist of advances from the FHLB. See Note 10 in the Notes to Consolidated Financial Statements contained in Item 8 of this report on Form 10-K. We are a member of and obtain advances from the FHLB, which is part of the Federal Home Loan Bank System. The eleven regional Federal Home Loan Banks provide a central credit facility for their member institutions. These advances are provided upon the security of certain of our mortgage loans and mortgage-backed securities. These advances may be made pursuant to several different credit programs, each of which has its own interest rate, range of maturities and call features, and all long-term advances are required to provide funds for residential home financing. We have entered into a loan agreement with the FHLB pursuant to which Sound Community Bank may borrow up to approximately 45% of total assets, secured by a blanket pledge on a portion of our residential mortgage portfolio including one- to four-family loans, commercial and 25 multifamily real estate loans and home equity loans. Based on eligible collateral, the total amount available under this agreement as of December 31, 2018 was $321.5 million. At the same date, we had $84.0 million in FHLB advances outstanding with maturities between zero and three years. We also had outstanding letters of credit from the FHLB with a notional amount of $14.5 million at December 31, 2018. We plan to rely in part on FHLB advances to fund asset and loan growth. We also use short-term advances to meet short term liquidity needs. We are required to own stock in the FHLB based on the amount of our advances. From time to time, we also may borrow from the Federal Reserve Bank of San Francisco’s ‘‘discount window’’ for overnight liquidity needs, although we have not borrowed from the discount window in recent years. The following table sets forth the maximum balance and average balance of borrowings for the periods indicated (dollars in thousands): Year Ended December 31, 2017 2016 2018 Maximum balance: FHLB advances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Average balances: FHLB advances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Weighted average interest rate: FHLB advances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $99,500 $61,500 $59,846 $69,900 $29,791 $36,609 2.18% 1.16% 0.58% The following table sets forth certain information about our borrowings at the dates indicated (dollars in thousands): FHLB advances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Weighted-average interest rate: FHLB advances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Subsidiary and Other Activities As of December 31, 2017 2016 2018 $84,000 $59,000 $54,792 2.72% 1.63% 0.82% Sound Financial Bancorp has one subsidiary, Sound Community Bank. In 2018, Sound Community Bank formed Sound Community Insurance Agency, Inc. as a wholly owned subsidiary for purposes of selling a full range of insurance products. Competition We face competition in attracting deposits and originating loans. Competition in originating real estate loans comes primarily from commercial banks, credit unions, life insurance companies, mortgage brokers and more recently financial technology (or ‘‘FinTech’’) companies. Commercial banks, credit unions and finance companies, including FinTech companies, provide vigorous competition in consumer lending. Commercial business competition is primarily from local commercial banks, but credit unions also compete for this business. We compete by consistently delivering high-quality, personal service to our clients which results in a high level of client satisfaction. Our market area has a high concentration of financial institutions, many of which are branches of large money center and regional banks that have resulted from the consolidation of the banking industry in Washington and other western states. These include such large national lenders as US Bank, JP Morgan Chase, Wells Fargo, Bank of America, Key Bank and others in our market area that have greater resources than we do. We attract our deposits through our branch offices and web site. Competition for those deposits is principally from savings banks, commercial banks and credit unions, as well as mutual funds, FinTech companies and other alternative investments. We compete for these deposits by offering superior service, online and mobile access and a variety of deposit accounts at competitive rates. Based on the most recent data provided by the FDIC, there are approximately 50 other commercial banks and savings banks operating in the Seattle MSA, which includes King, Snohomish and Pierce Counties. Based on the most recent branch deposit data provided by the FDIC, our share of deposits in the Seattle MSA is approximately 0.2%. The five largest financial institutions in that area have 26 71.2% of those deposits. In Clallam County there are nine other commercial banks and savings banks. Our share of deposits in Clallam County was the second highest in the county at approximately 16.5%, with the five largest institutions in that county having 76.9% of the deposits. In Jefferson County there are six other commercial banks and savings banks. Our share of deposits in Jefferson County is approximately 6.8%, while the five largest institutions in that county have 82.0% of those deposits. How We Are Regulated General. Sound Community Bank is a Washington state-chartered commercial bank. The regulators of Sound Community Bank as a commercial bank are the WDFI and the FDIC. The Federal Reserve is the primary federal regulator for Sound Financial Bancorp. A brief description of certain laws and regulations that are applicable to Sound Financial Bancorp and Sound Community Bank is set forth below. This description of these laws and regulations, as well as descriptions of laws and regulations contained elsewhere herein, does not purport to be complete and is qualified in its entirety by reference to the applicable laws and regulations. Legislation is introduced from time to time in the United States Congress or the Washington State Legislature that may affect the operations of Sound Financial Bancorp and Sound Community Bank. In addition, the regulations governing us may be amended from time to time. Any such legislation or regulatory changes in the future could adversely affect our operations and financial condition. The WDFI and FDIC have extensive enforcement authority over Sound Community Bank. The Federal Reserve has the same type of authority over Sound Financial Bancorp. This enforcement authority includes, among other things, the ability to assess civil money penalties, issue cease-and-desist orders and removal orders and initiate injunctive actions. In general, these enforcement actions may be initiated for violations of laws and regulations and unsafe or unsound practices. Other actions or inactions may provide the basis for enforcement action, including misleading or untimely reports filed with the regulators. Regulatory Reform. On July 21, 2010, the President signed into law the Dodd-Frank Act. The Dodd-Frank Act imposed various restrictions and an expanded framework of regulatory oversight for financial institutions, including depository institutions. The following discussion summarizes significant aspects of the Dodd-Frank Act that affect us. The following aspects of the Dodd-Frank Act, among others, are related to our operations: • • • • • • • The Consumer Financial Protection Bureau (the ‘‘CFPB’’), an independent consumer compliance regulatory agency, was established within the Federal Reserve. The CFPB is empowered to exercise broad regulatory, supervisory and enforcement authority over financial institutions with total assets over $10 billion with respect to both new and existing consumer financial protection laws. Smaller financial institutions, like Sound Community Bank, are subject to supervision and enforcement by their primary federal banking regulator with respect to federal consumer financial protection laws and regulations. The CFPB also has authority to promulgate new consumer financial protection regulations and amend existing consumer financial protection regulations. The Federal Reserve must require depository institution holding companies to serve as a source of strength for their depository institution subsidiaries. The prohibition on payment of interest on demand deposits was repealed. Deposit insurance increased to $250,000. The deposit insurance assessment base for FDIC insurance is the depository institution’s average consolidated total assets less average tangible equity during the assessment period. The minimum reserve ratio of the Deposit Insurance Fund (‘‘DIF’’) increased to 1.35 percent of estimated annual insured deposits or the comparable percentage of the assessment base; however, the FDIC is directed to offset the effect of the increased reserve ratio for insured depository institutions with total consolidated assets of less than $10 billion. Pursuant to the Dodd-Frank Act, the FDIC issued a rule setting a designated reserve ratio at 2.0% of insured deposits. Tier 1 capital treatment for ‘‘hybrid’’ capital items like trust preferred securities was eliminated subject to various grandfathering and transition rules. The federal banking agencies have promulgated rules on 27 • • • regulatory capital for both depository institutions and their holding companies, including leverage capital and risk-based capital measures at least as stringent as those applicable to Sound Community Bank under the prompt corrective action regulations. See ‘‘— Capital Rules’’ A separate, non-binding shareholder vote is required regarding golden parachutes for named executive officers when a shareholder vote takes place on mergers, acquisitions, dispositions or other transactions that would trigger the parachute payments. Securities exchanges are required to prohibit brokers from using their own discretion to vote shares not beneficially owned by them for certain ‘‘significant’’ matters, which include votes on the election of directors, executive compensation matters, and any other matter determined to be significant. Stock exchanges, not including the OTC Bulletin Board, are prohibited from listing the securities of any issuer that does not have a policy providing for (i) disclosure of its policy on incentive compensation that is based on financial information required to be reported under the securities laws, and (ii) the recovery from current or former executive officers, following an accounting restatement triggered by material noncompliance with securities law reporting requirements, of any incentive compensation paid erroneously during the three-year period preceding the date on which the restatement was required that exceeds the amount that would have been paid on the basis of the restated financial information. 2018 Regulatory Reform In May 2018, the Economic Growth, Regulatory Relief and Consumer Protection Act (the ‘‘Act’’), was enacted to modify or remove certain financial reform rules and regulations, including some of those implemented under the Dodd-Frank Act. While the Act maintains most of the regulatory structure established by the Dodd-Frank Act, it amends certain aspects of the regulatory framework for depository institutions with assets of less than $10 billion and for large banks with assets of more than $50 billion. Many of these changes could result in meaningful regulatory changes for community banks such as Sound Community Bank, and their holding companies. The Act, among other matters, expands the definition of qualified mortgages which may be held by a financial institution and simplifies the regulatory capital rules for financial institutions and their holding companies with total consolidated assets of less than $10 billion by instructing the federal banking regulators to establish a single Community Bank Leverage Ratio of between 8 and 10 percent. Any qualifying depository institution or its holding company that exceeds that ratio will be considered to have met generally applicable leverage and risk-based regulatory capital requirements and any qualifying depository institution that exceeds the new ratio will be considered to be ‘‘well capitalized’’ under the prompt corrective action rules. The Act also expands the category of holding companies that may rely on the Small Bank Holding Company and Savings and Loan Holding Company Policy Statement of the Federal Reserve by raising the maximum amount of assets a qualifying holding company may have from $1 billion to $3 billion. A major effect of this change is to exclude such holding companies from the minimum capital requirements of the Dodd-Frank Act. In addition, the Act includes regulatory relief for community banks regarding regulatory examination cycles, call reports, the Volcker Rule (proprietary trading prohibitions), mortgage disclosures and risk weights for certain high-risk commercial real estate loans. It is difficult at this time to predict when or how any new standards under the Act will ultimately be applied to us or what specific impact the Act and the yet-to-be-written implementing rules and regulations will have on community banks. Regulation of Sound Community Bank General. Sound Community Bank, as a state-chartered commercial bank, is subject to applicable provisions of Washington law and to regulations and examinations of the WDFI. As an insured institution, it also is subject to examination and regulation by the FDIC, which insures the deposits of Sound Community Bank to the maximum permitted by law. During state or federal regulatory examinations, the examiners may require Sound Community Bank to provide for higher general or specific loan loss reserves, which can impact our capital and earnings. This regulation of Sound Community Bank is intended for the protection of depositors and the Deposit Insurance Fund of the FDIC and not for the purpose of protecting shareholders of Sound Community Bank or Sound 28 Financial Bancorp. Sound Community Bank is required to maintain minimum levels of regulatory capital and is subject to certain limitations on the payment of dividends to Sound Financial Bancorp. See ‘‘— Capital Rules’’ and ‘‘— Limitations on Dividends and Other Capital Distributions.’’ Regulation by the WDFI and the FDIC. State law and regulations govern Sound Community Bank’s ability to take deposits and pay interest, to make loans on or invest in residential and other real estate, to make other loans, to invest in securities, to offer various banking services to its clients, and to establish branch offices. As a state commercial bank, Sound Community Bank must pay semi-annual assessments, examination costs and certain other charges to the WDFI. Washington law generally provides the same powers for Washington commercial banks as federally and other-state chartered savings banks with branches in Washington. Washington law allows Washington commercial banks to charge the maximum interest rates on loans and other extensions of credit to Washington residents which are allowable for a national bank in another state if higher than Washington limits. In addition, the WDFI may approve applications by Washington commercial banks to engage in an otherwise unauthorized activity, if it determines that the activity is closely related to banking, and Sound Community Bank is otherwise qualified under the statute. Federal law and regulations generally limit the activities and equity investments of Sound Community Bank to those that are permissible for national banks, unless approved by the FDIC, and govern our relationship with our depositors and borrowers to a great extent, especially with respect to disclosure requirements. The FDIC has adopted regulatory guidelines establishing safety and soundness standards on such matters as loan underwriting and documentation, asset quality, earnings standards, internal controls and information systems, audit systems, interest rate risk exposure and compensation and other benefits. If the FDIC determines that Sound Community Bank fails to meet any standard prescribed by these guidelines, it may require Sound Community Bank to submit an acceptable plan to achieve compliance with the standard. Among these safety and soundness standards are FDIC regulations that require Sound Community Bank to adopt and maintain written policies that establish appropriate limits and standards for real estate loans. These standards, which must be consistent with safe and sound banking practices, establish loan portfolio diversification standards, prudent underwriting standards (including loan-to-value ratio limits) that are clear and measurable, loan administration procedures, and documentation, approval and reporting requirements. Sound Community Bank is obligated to monitor conditions in its real estate markets to ensure that its standards continue to be appropriate for current market conditions. Sound Community Bank’s board of directors is required to review and approve Sound Community Bank’s standards at least annually. The FDIC has published guidelines for compliance with these regulations, including supervisory limitations on loan-to-value ratios for different categories of real estate loans. Under the guidelines, the aggregate level of all loans in excess of the supervisory loan-to-value ratios should not exceed an aggregate limit of 100% of total capital, and within the aggregate limit, the total of all loans for commercial, agricultural, multifamily or other non-one- to four-family residential properties should not exceed 30% of total capital. Loans in excess of the supervisory loan-to-value ratio limitations must be identified in Sound Community Bank’s records and reported at least quarterly to Sound Community Bank’s Board of Directors. Sound Community Bank is in compliance with the records and reporting requirements. As of December 31, 2018, Sound Community Bank’s aggregate loans in excess of the supervisory loan-to-value ratios were $5.8 million. The FDIC and the WDFI must approve any merger transaction involving Sound Community Bank as the acquirer, including an assumption of deposits from another depository institution. The FDIC generally is authorized to approve interstate merger transactions without regard to whether the transaction is prohibited by the law of any state. Interstate acquisitions of branches are permitted only if the law of the state in which the branch is located permits such acquisitions. Interstate mergers and branch acquisitions are also be subject to the nationwide and statewide insured deposit concentration amounts described below. The Dodd-Frank Act permits de novo interstate branching for banks. Insurance of Accounts. The FDIC insures deposit accounts in Sound Community Bank up to $250,000 per separately insured deposit ownership right or category. The FDIC assesses deposit insurance premiums quarterly on each FDIC-insured institution applied to its deposit base, which is their average consolidated total assets minus its Tier 1 capital. No institution may pay a dividend if it is in default on its federal deposit insurance assessment. 29 The FDIC calculates assessments for small institutions (those with assets of less than $10 billion) based on an institution’s weighted average CAMELS component ratings and certain financial ratios. Currently, assessment rates range from 3 to 16 basis points for institutions with CAMELS composite ratings of 1 or 2, 6 to 30 basis points for those with CAMELS composite ratings of 3, and 16 to 30 basis points for those with CAMELS composite ratings of 4 or 5, all subject to certain adjustments. Assessment rates are expected to decrease in the future as the reserve ratio increases in specified increments. As required by the Dodd Frank Act, the FDIC has adopted a rule to offset the effect of the increase in the minimum reserve ratio of the DIF on small institutions by imposing a surcharge on institutions with assets of $10 billion or more commencing on July 1, 2016 and ending when the reserve ratio reaches 1.35%, which, the FDIC announced occurred on September 30, 2018. When the reserve ratio reaches 1.38%, small institutions will receive credits for the portions of their regular assessments that contributed to growth in the reserve ratio between 1.15% and 1.35%. Subject to certain limitations, the credits will apply to reduce regular assessments until exhausted. Transactions with Related Parties. Transactions between Sound Community Bank and its affiliates are required to be on terms as favorable to Sound Community Bank as transactions with non-affiliates, and certain of these transactions, such as loans to an affiliate, are restricted to a percentage of Sound Community Bank’s capital and require eligible collateral in specified amounts. Sound Financial Bancorp is an affiliate of Sound Community Bank. The Sarbanes-Oxley Act of 2002 generally prohibits loans by Sound Financial Bancorp to its executive officers and directors. However, the law contains a specific exception for loans by a depository institution to its executive officers and directors in compliance with federal banking laws. Under such laws, Sound Community Bank’s authority to extend credit to executive officers, directors and 10% or greater shareholders (‘‘insiders’’), as well as entities such persons control, is limited. The laws limit both the individual and aggregate amount of loans that Sound Community Bank may make to insiders based, in part, on Sound Community Bank’s capital level and requires that certain board approval procedures be followed. Such loans are required to be made on terms substantially the same as those offered to unaffiliated borrowers and must not involve more than the normal risk of repayment. There is an exception for loans made pursuant to a benefit or compensation program that is widely available to all employees of the institution and does not give preference to insiders over other employees. Loans to executive officers are subject to additional limitations based on the type of loan involved. Capital Rules. Effective January 1, 2015 (with some provisions transitioned into full effectiveness over several years), Sound Community Bank is subject to the capital regulations adopted by the Federal Reserve and the FDIC pursuant to the Dodd-Frank Act. Under these capital regulations, the minimum capital ratios are: (1) a common equity Tier 1 (‘‘CET1’’) capital ratio of 4.5% of risk-weighted assets; (2) a Tier 1 capital ratio of 6.0% of risk-weighted assets; (3) a total capital ratio of 8.0% of risk-weighted assets, and (4) a leverage ratio (the ratio of Tier 1 capital to average total adjusted assets) of 4.0%. CET1 generally consists of common stock, retained earnings, accumulated other comprehensive income (‘‘AOCI’’) unless an institution elects to exclude AOCI from regulatory capital, as discussed below, and certain minority interests, all subject to applicable regulatory adjustments and deductions. Tier 1 capital generally includes CET1 and noncumulative perpetual preferred stock, less most intangible assets, subject to certain adjustments. Total capital consists of Tier 1 and Tier 2 Capital. Tier 2 capital, which is limited to 100 percent of Tier 1 capital, includes such items as qualifying general loan loss reserves, cumulative perpetual preferred stock, mandatory convertible debt, term subordinated debt and limited life preferred stock; however, the amount of term subordinated debt and intermediate term preferred stock that may be included in Tier 2 capital is limited to 50 percent of Tier 1 capital. Risk-weighted assets are determined under the capital regulations, which assign risk-weights to all assets and to certain off-balance sheet items. These regulations include the phasing-out of certain instruments as qualifying capital. Mortgage servicing and deferred tax assets over designated percentages of CET1 are deducted from capital. In addition, Tier 1 capital includes AOCI, which includes all unrealized gains and losses on available for sale debt and equity securities, unless an institution elects to opt out of such inclusion, if eligible to do so. We have elected to permanently opt-out of the inclusion of AOCI in our capital calculations. The capital regulations include a 150% risk weight for certain high volatility commercial real estate acquisition, development and construction loans and for non-residential mortgage loans that are 90 days past due or 30 otherwise in nonaccrual status; a 20% risk weight for the unused portion of a commitment with an original maturity of one year or less that is not unconditionally cancellable; and a 250% risk weight for mortgage servicing and deferred tax assets that are not deducted from capital. In addition to the minimum CET1, Tier 1 and total capital ratios, Sound Financial Bancorp and Sound Community Bank must maintain a capital conservation buffer consisting of additional CET1 capital greater than 2.5% of risk-weighted assets above the required minimum risk-based capital levels in order to avoid limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses. The capital conservation buffer requirement began to phase in on January 1, 2016, when a buffer greater than 0.625% of risk-weighted assets was required, which amount increased each year until the buffer requirement was fully implemented on January 1, 2019. Under the FDIC’s prompt corrective action standards, in order to be considered well-capitalized, 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. An institution that is not well capitalized is subject to certain restrictions on brokered deposits and interest rates on deposits. An institution that is not at least adequately capitalized is subject to numerous additional restrictions, and a guaranty by its holding company is required. An institution with a ratio of tangible equity to total assets of 2.0% or less is subject to appointment of the FDIC as receiver if its capital level does not improve in timely fashion. When the FDIC as receiver liquidates an institution, the claims of depositors and the FDIC as their successor have priority over other unsecured claims against the institution. The Financial Accounting Standards Board has adopted a new accounting standard for US Generally Accepted Accounting Principles that will be effective for us for our first fiscal year beginning after December 15, 2019. This standard, referred to as Current Expected Credit Loss, or CECL, requires FDIC-insured institutions and their holding companies (banking organizations) to recognize credit losses expected over the life of certain financial assets. CECL covers a broader range of assets than the current method of recognizing credit losses and generally results in earlier recognition of credit losses. Upon adoption of CECL, a banking organization must record a one-time adjustment to its credit loss allowances as of the beginning of the fiscal year of adoption equal to the difference, if any, between the amount of credit loss allowances under the current methodology and the amount required under CECL. For a banking organization, implementation of CECL is generally likely to reduce retained earnings, and to affect other items, in a manner that reduces its regulatory capital. The federal banking regulators (the Federal Reserve, the Office of the Comptroller of the Currency and the FDIC) have adopted a rule that gives a banking organization the option to phase in over a three-year period the day-one adverse effects of CECL on its regulatory capital. As of December 31, 2018, Sound Community Bank was well capitalized under applicable regulations and met the fully phased-in capital conservation buffer requirement. Volcker Rule Regulations. Regulations were adopted by the federal banking agencies to implement the provisions of the Dodd Frank Act commonly referred to as the Volcker Rule. The regulations contain prohibitions and restrictions on the ability of banks and their holding companies and the affiliates to engage in proprietary trading and to hold certain interests in, or to have certain relationships with, various types of investment funds, including hedge funds and private equity funds, and certain other investments, including certain collateralized mortgage obligations, collateralized debt obligations, collateralized loan obligations and others. Community Reinvestment and Consumer Protection Laws. In connection with its lending and other activities, Sound Community Bank is subject to a number of federal laws designed to protect clients and promote lending 31 to various sectors of the economy and population. These include, among others, the Equal Credit Opportunity Act, the Truth-in-Lending Act, the Home Mortgage Disclosure Act, the Real Estate Settlement Procedures Act, and the Community Reinvestment Act (‘‘CRA’’). Among other things, these laws: • • • • • • • • require lenders to disclose credit terms in meaningful and consistent ways; prohibit discrimination against an applicant in a credit transaction; prohibit discrimination in housing-related lending activities; require certain lenders to collect and report applicant and borrower data regarding home loans; require lenders to provide borrowers with information regarding the nature and cost of real estate settlements; prohibit certain lending practices and limit escrow account amounts with respect to real estate loan transactions; require financial institutions to implement identity theft prevention programs and measures to protect the confidentiality of consumer financial information; and prescribe possible penalties for violations of the requirements of consumer protection statutes and regulations. The CFPB has authority to amend existing consumer protection regulations and implement new regulations, and is charged with examining the compliance of financial institutions with assets in excess of $10 billion with these rules. Sound Community Bank’s compliance with consumer protection rules is examined by the WDFI and the FDIC. In addition, federal regulations limit the ability of banks and other financial institutions to disclose nonpublic consumer information to non-affiliated third parties. The regulations require disclosure of privacy policies and allow consumers to prevent certain personal information from being shared with non-affiliated parties. The CRA requires the appropriate federal banking agency to assess the bank’s record in meeting the credit needs of the communities served by the bank, including low and moderate income neighborhoods. The FDIC examines Sound Community Bank for compliance with its CRA obligations. Under the CRA, institutions are assigned a rating of ‘‘outstanding,’’ ‘‘satisfactory,’’ ‘‘needs to improve,’’ or ‘‘substantial non-compliance’’ and the appropriate federal banking agency is to take this rating into account in the evaluation of certain applications of the institution, such as an application relating to a merger or the establishment of a branch. An unsatisfactory rating may be the basis for the denial of such an application. The CRA also requires that all institutions make public disclosures of their CRA ratings. Sound Community Bank received a ‘‘satisfactory’’ rating in its most recent CRA evaluation. Under the law of the state of Washington, Sound Community Bank has a similar obligation to meet the credit needs of the communities it serves, and is subject to examination by the WDFI for this purpose, including assignment of a rating. An unsatisfactory rating may be the basis for denial of certain applications by the WDFI. Bank Secrecy Act / Anti-Money Laundering Laws. Sound Community Bank is subject to the Bank Secrecy Act and other anti-money laundering laws and regulations, including the USA PATRIOT Act of 2001. These laws and regulations require Sound Community Bank to implement policies, procedures, and controls to detect, prevent, and report money laundering and terrorist financing and to verify the identity of their clients. Violations of these requirements can result in substantial civil and criminal sanctions. In addition, provisions of the USA PATRIOT Act require the federal financial institution regulatory agencies to consider the effectiveness of a financial institution’s anti-money laundering activities when reviewing mergers and acquisitions. Federal Home Loan Bank System. Sound Community Bank is a member of the FHLB, one of the 11 regional Federal Home Loan Banks in the Federal Home Loan Bank System. The Federal Home Loan Bank System provides a central credit facility for member institutions. As a member of the FHLB, the Bank is required to hold shares of capital stock in that FHLB. At December 31, 2018, the Bank had $4.1 million in FHLB stock, which was in compliance with this requirement. Sound Community Bank received $174,000 in dividends from the FHLB for the year ended December 31, 2018. 32 The Federal Home Loan Banks have continued to contribute to low- and moderately-priced housing programs through direct loans or interest subsidies on advances targeted for community investment and low- and moderate-income housing projects. These contributions have affected adversely the level of dividends paid by the FHLB and could continue to do so in the future. These contributions could also have an adverse effect on the value of FHLB stock in the future. A reduction in value of Sound Community Bank’s FHLB stock may result in a corresponding reduction in its capital. Regulation of Sound Financial Bancorp General. Sound Financial Bancorp, as the sole shareholder of Sound Community Bank, is a bank holding company registered with the Federal Reserve. Bank holding companies are subject to comprehensive regulation by the Federal Reserve under the Bank Holding Company Act of 1956, as amended, and the regulations promulgated thereunder. This regulation and oversight is generally intended to ensure that Sound Financial Bancorp limits its activities to those allowed by law and that it operates in a safe and sound manner without endangering the financial health of Sound Community Bank. As a bank holding company, Sound Financial Bancorp is required to file quarterly and annual reports with the Federal Reserve and any additional information required by the Federal Reserve and is subject to regular examinations by the Federal Reserve and to examination by the WDFI. A merger or acquisition of Sound Financial Bancorp, or an acquisition of control of Sound Financial Bancorp, is generally subject to approval by the Federal Reserve and WDFI. In general, control for this purpose means 25% of voting stock, but such approval can be required in other circumstances, including but not limited to an acquisition of as low as 5% of voting stock. The Dodd-Frank Act requires a bank holding company to serve as a source of financial strength to its subsidiary banks, with the ability to provide financial assistance to a subsidiary bank in financial distress. Regulations to implement this provision are required, but to date, none have been promulgated. Permissible Activities. Under the Bank Holding Company Act, the Federal Reserve may approve the ownership of shares by a bank holding company in any company the activities of which the Federal Reserve has determined to be so closely related to the business of banking or managing or controlling banks as to be a proper incident thereto. The Bank Holding Company Act prohibits a bank holding company, with certain exceptions, from acquiring ownership or control of more than 5% of the voting shares of any company that is not a bank or bank holding company and from engaging in activities other than those of banking, managing or controlling banks, or providing services for its subsidiaries. A bank holding company that meets certain supervisory and financial standards and elects to be designed as a financial holding company may also engage in certain securities, insurance and merchant banking activities and other activities determined to be financial in nature or incidental to financial activities. The Federal Reserve must approve an application of a bank holding company to acquire control of, or acquire all or substantially all of the assets of, a bank, and may approve an acquisition located in a state other than the holding company’s home state, without regard to whether the transaction is prohibited by the laws of any state, but may not approve the acquisition of a bank that has not been in existence for the minimum time period, not exceeding five years, specified by the law of the host state, or an application where the applicant controls or would control more than 10% of the insured deposits in the United States or 30% or more of the deposits in the target bank’s home state or in any state in which the target bank maintains a branch. Federal law does not affect the authority of states to limit the percentage of total insured deposits in the state that may be held or controlled by a bank holding company to the extent such limitation does not discriminate against out-of-state banks or bank holding companies. Individual states may also waive the 30% state-wide concentration limit contained in the federal law. The Federal Reserve also takes into consideration the CRA performance of a bank when evaluating acquisition proposals involving the bank’s holding company. Capital Requirements for Sound Financial Bancorp. As discussed above, pursuant to the Act, effective August 30, 2018, bank holding companies with less than $3.0 billion in consolidated assets are generally no longer subject to the Federal Reserve’s capital regulations, which are essentially the same as the capital regulations applicable to Sound Community Bank described under the caption ‘‘Capital Rules’’ above. If Sound Financial Bancorp were subject to regulatory guidelines for bank holding companies with $3.0 billion or more in assets at December 31, 2018, the Company would have exceeded all regulatory requirements. The Federal 33 Reserve expects a holding company’s subsidiary banks to be well capitalized under the prompt corrective action regulations. In addition, a bank holding company must serve as a source of financial strength for its depository institution subsidiaries. Federal Securities Law. The stock of Sound Financial Bancorp is registered with the SEC under the Securities Exchange Act of 1934, as amended. Sound Financial Bancorp is subject to the information, proxy solicitation, insider trading restrictions and other requirements of the SEC under the Securities Exchange Act of 1934 (the ‘‘Exchange Act’’). Sound Financial Bancorp stock held by persons who are affiliates of Sound Financial Bancorp may not be resold without registration unless sold in accordance with certain resale restrictions. For this purpose, affiliates are generally considered to be officers, directors and principal shareholders. If Sound Financial Bancorp meets specified current public information requirements, each affiliate of Sound Financial Bancorp will be able to sell in the public market, without registration, a limited number of shares in any three-month period. The SEC has adopted regulations and policies under the Sarbanes-Oxley Act of 2002 that apply to Sound Financial Bancorp as a registered company under the Exchange Act. The stated goals of these requirements are to increase corporate responsibility, provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws. The SEC and Sarbanes-Oxley-related regulations and policies include very specific additional disclosure requirements and corporate governance rules. Limitations on Dividends and Stock Repurchases Sound Financial Bancorp. Sound Financial Bancorp’s ability to declare and pay dividends is subject to the Federal Reserve’s limits, including the capital conservation buffer requirement, and Maryland law, and may depend on its ability to receive dividends from Sound Community Bank. A policy of the Federal Reserve limits the payment of a cash dividend by a bank holding company if the holding company’s net income for the past year is not sufficient to cover both the cash dividend and a rate of earnings retention that is consistent with capital needs, asset quality and overall financial condition. A bank holding company that does not meet any applicable capital standard would not be able to pay any cash dividends under this policy. A bank holding company subject to the Small Bank Holding Company Policy Statement, such as Sound Financial Bancorp, is expected not to pay dividends unless its debt-to-equity ratio is less than 1:1 and it meets certain additional criteria. The Federal Reserve also has indicated that it is inappropriate for a company experiencing serious financial problems to borrow funds to pay dividends. Except for a company that meets the well-capitalized standard for bank holding companies, is well managed, and is not subject to any unresolved supervisory issues, a bank holding company is required to give the Federal Reserve prior written notice of any purchase or redemption of its outstanding equity securities if the gross consideration for the purchase or redemption, when combined with the net consideration paid for all such purchases or redemptions during the preceding 12 months, is equal to 10% or more of the company’s consolidated net worth. The Federal Reserve may disapprove such a purchase or redemption if it determines that the proposal would constitute an unsafe or unsound practice or would violate any law, regulation or regulatory order, condition, or written agreement with the Federal Reserve. Regardless of its asset size, a bank holding company is considered well-capitalized if on a consolidated basis it has a total risk-based capital ratio of at least 10.0% and a Tier 1 risk-based capital ratio of 6.0% or more, and is not subject to an agreement, order, or directive to maintain a specific level for any capital measure. Under Maryland corporate law, Sound Financial Bancorp generally may not pay dividends if after that payment it would not be able to pay its liabilities as they become due in the usual course of business, or its total assets would be less than the sum of its total liabilities. Sound Community Bank. The amount of dividends payable by Sound Community Bank to Sound Financial Bancorp depends upon Sound Community Bank’s earnings and capital position, and is limited by federal and state laws, regulations and policies, including the capital conservation buffer requirement. Sound Community Bank may not declare or pay a cash dividend on its capital stock if the payment would cause its net worth to be reduced below the amount required for its liquidation account. Dividends on Sound Community Bank’s capital stock may not be paid in an aggregate amount greater than the aggregate retained earnings of Sound Community Bank without the approval of the WDFI. 34 The amount of dividends actually paid during any one period will be strongly affected by Sound Community Bank’s policy of maintaining a strong capital position. Federal law further provides that without prior approval no insured depository institution may pay a cash dividend if it would cause the institution to be less than adequately capitalized as defined in the prompt corrective action regulations. Moreover, the FDIC has the general authority to limit the dividends paid by insured banks if such payments are deemed to constitute an unsafe and unsound practice. In addition, dividends may not be declared or paid if Sound Community Bank is in default in payment of any assessment due the FDIC. Federal Taxation General. We are subject to federal income taxation in the same general manner as other corporations, with some exceptions discussed below. The following discussion of federal taxation is intended only to summarize certain pertinent federal income tax matters and is not a comprehensive description of the tax rules applicable to Sound Financial Bancorp or Sound Community Bank. Our federal income tax returns have never been audited by the Internal Revenue Service. On December 22, 2017, the U.S. Government enacted the Tax Cuts and Jobs Act (the ‘‘Tax Act’’). For businesses, the Tax Act reduced the federal corporate income tax rate from 35 percent to 21 percent. The corporate income tax rate reduction was effective January 1, 2018. The Tax Act required a revaluation of the Company’s deferred tax assets and liabilities to account for the future impact of lower corporate tax rates and other provisions of the legislation. As a result of the Company’s revaluation, the Company’s deferred tax asset was reduced through one time $309,000 increase to the provision for income tax for the year ended December 31, 2017. The Company had no unrecognized tax benefits at December 31, 2018 and at December 31, 2017. Method of Accounting. For federal income tax purposes, we currently report our income and expenses on the accrual method of accounting and use a fiscal year ending on December 31 for filing our federal income tax return. Minimum Tax. The Internal Revenue Code imposes an alternative minimum tax at a rate of 20% on a base of regular taxable income plus certain items of tax preference and adjustment, called alternative minimum taxable income. Net operating losses can offset no more than 90% of alternative minimum taxable income. The alternative minimum tax is payable to the extent that the taxpayer’s alternative minimum tax is in excess of the taxpayer’s regular tax. Certain payments of alternative minimum tax may be used as credits against regular tax liabilities in future years. We have not been subject to the alternative minimum tax in prior years, nor do we have any such amounts available as credits for carryover. Corporate Dividends-Received Deduction. Sound Financial Bancorp has elected to file a consolidated return with Sound Community Bank. Therefore any dividends Sound Financial Bancorp receives from Sound Community Bank will not be included as income to Sound Financial Bancorp. State Taxation We are subject to a business and occupation tax imposed under Washington state law at the rate of 1.5% of gross receipts. Interest received and servicing income on loans secured by mortgages or deeds of trust on residential properties and certain investment securities are exempt from this tax. Employees At December 31, 2018, we had a total of 109 full-time employees and 10 part-time employees. Our employees are not represented by any collective bargaining group. Management considers its employee relations to be good. Executive Officers of Sound Financial Bancorp and Sound Community Bank Officers are elected annually to serve for a one year term. There are no arrangements or understandings between the officers and any other person pursuant to which he or she was or is to be selected as an officer. Laura Lee Stewart. Ms. Stewart, age 69, is currently President and Chief Executive Officer of Sound Community Bank and Sound Financial Bancorp. Prior to joining Sound Community Bank as its President in 1989, when it was a credit union, Ms. Stewart was Senior Vice President/Retail Banking at Great Western Bank. 35 Ms. Stewart was selected as an inaugural member of the FDIC Community Bank Advisory Board and completed her term in 2011. In 2011, Ms. Stewart was appointed to the inaugural Consumer Financial Protection Bureau board and completed her term in 2013. She also served as Chair of the American Bankers Association’s (ABA) Government Relations Council and is the past Chair of the Washington Bankers Association. The American Banker magazine honored her as one of the top 25 Women to Watch in banking in 2011, 2015, 2016, 2017 and 2018. In 2016, Ms. Stewart was recognized as a Women of Influence by the Puget Sound Business Journal. In 2018, she was named Community Banker of the year by American Banker. Ms. Stewart also is Chair of the National Arthritis Foundation’s board of directors as well as serving as the immediate Past Chair of the board of directors of Woodland Park Zoo. In October 2017, Ms. Stewart was elected Chair elect of the ABA. Her many years of service in all areas of the financial institution operations and duties as President and Chief Executive Officer of Sound Financial Bancorp and Sound Community Bank bring a special knowledge of the financial, economic and regulatory challenges we face, and she is well suited to educating the Board on these matters. Elliott Pierce. Mr. Pierce, age 62, was appointed Senior Vice President and Chief Credit Officer of Sound Community Bank in April 2015 and was appointed Executive Vice President in January 2016. Mr. Pierce is responsible for management of the Bank’s Lending and Credit Administration functions, and is a member of the Bank’s Loan Committee. Prior to joining Sound Community Bank, Mr. Pierce was a Senior Vice President and Credit Administrator with Union Bank N.A. Mr. Pierce received his Bachelor of Arts Degree from the University of Washington and his Master of Business Administration from Seattle Pacific University. Mr. Pierce is also a graduate of the Pacific Coast Banking School. Christina Gehrke. Ms. Gehrke, age 54, was appointed Senior Vice President and Chief Administrative Officer of Sound Community Bank in October 2015 and was appointed Executive Vice President in January 2017. Her responsibilities include, among other things, overseeing internal audit, SOX program, vendor management program, human resources, and facilities functions at the Bank. Ms. Gehrke previously served as Chief Accounting and Administrative Officer of the Federal Home Loan Bank of Seattle (‘‘FHLB Seattle’’) where she was employed for 17 years. Ms. Gehrke’s responsibilities at the FHLB Seattle included overseeing the accurate and timely reporting of SEC periodic reports, the preparation of consolidated financial statements, SEC reporting and analysis, compliance with SOX policies and procedures, data management as well as facilities management. Heidi Sexton. Ms. Sexton, age 43, is Executive Vice President, Chief Operating Officer responsible for oversight of the Bank’s support functions, including Information Technology, Marketing, Retail Support, Compliance, Enterprise Risk Management, and Project Management. Ms. Sexton started her career in Banking, as a teller while in college. She received a Bachelor’s of Arts in Accounting from the University of Wisconsin-Eau Claire. Ms. Sexton joined Sound Community Bank in 2007 and previously served as the Vice President of Operations managing deposit, electronic, and lending operations. Prior to joining the Bank, Ms. Sexton was a Director for RSM McGladrey. She currently holds a number of professional certifications including Certified Internal Auditor, Certified Regulatory Compliance Manager and is a graduate of the Washington Bankers Association’s Executive Development Program. Ms. Sexton is also a member of the Consumer Financial Protection Bureau’s (CFPB) Community Bank Advisory Counsel and American Bankers Association’s (ABA) Compliance Administrative Committee. She serves on the Board of Financial Beginnings, a non-profit that provides youth to adult financial education programs at no cost. Daphne Kelley. Ms. Kelley, age 47, is currently Executive Vice President, Chief Financial Officer at Sound Financial Bancorp and Sound Community Bank. Prior to joining the Bank in July 2018, Ms. Kelley was Senior Vice President, Controller of HomeStreet Bank where she was responsible for SEC and regulatory reporting, accounting operations, corporate tax and Sarbanes-Oxley. Additional experience includes the Controller role at the Federal Home Loan Bank of Seattle as well as various roles at GE Capital, Toyota and Ernst & Young. Ms. Kelley received a Bachelor’s of Science degree from the University of California at Berkeley and a Masters of Business Administration from UCLA Anderson School of Management. She currently holds a Certified Public Accountant license in the State of Washington and the State of California. Website We maintain a website; www.soundcb.com. The information contained on our website is not included as a part of, or incorporated by reference into, this Annual Report on Form 10-K. Other than an investor’s own internet access charges, we make available free of charge through its website the Annual Report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and amendments to these reports, as soon as reasonably 36 practicable after we have electronically filed such material with, or furnished such material to, the SEC. Information pertaining to us, including SEC filings, can be found by clicking the link on our site called ‘‘Investor Relations.’’ For more information regarding access to these filings on our website, please contact our Corporate Secretary, Sound Financial Bancorp, Inc., 2400 3rd Avenue, Suite 150, Seattle, Washington, 98121 or by calling (206) 448-0884. Item 1A. Risk Factors Not required; we are a smaller reporting company. Item 1B. Unresolved Staff Comments Not applicable. Properties Item 2. Seven of our ten offices are leased. The operating leases contain renewal options and require us to pay property taxes and operating expenses for the properties. Our total rental expense for each of the years ended December 31, 2018 and 2017 was $1.4 million and $1.1 million, respectively. The aggregate net book value of our land, buildings, leasehold improvements, furniture and equipment was $7.0 million at December 31, 2018. See also Note 7 in the Notes to Consolidated Financial Statements contained in Item 8 of this report on Form 10-K. In the opinion of management, the facilities are adequate and suitable for our current needs. We may open additional banking offices to better serve current clients and to attract new clients in subsequent years. The following table sets forth certain information concerning our main office, our branch offices and our loan production office at December 31, 2018: Location Main office: Third and Battery Seattle, WA 98121 Branch offices: Cedar Plaza Branch 22807 44th Avenue West Mountlake Terrace, WA 98043 Port Angeles Branch 110 N. Alder Street Port Angeles, WA 98682 Port Ludlow Branch 9500 Oak Bay Road, Suite A. Port Ludlow, WA 98365 Seattle Branch 2001 5th Avenue Seattle, WA 98121 Sequim Branch 645 W. Washington Street Sequim, WA 98382 Tacoma Branch 2941 S. 38th Street Tacoma, WA 98409 University Place Branch 4922 Bridgeport Way West University Place, WA 98467 Year opened Owned or leased Lease expiration date 2017 Leased 2029(1) 2004 Leased 2025(2) 2010 Leased 2028(3) 2014 Owned 1993 Leased 2020(4) 1997 Owned 2009 Leased 2019(3) 2017 Leased 2023(2) 37 Location Year opened Owned or leased Lease expiration date Loan Production Offices: Creekside Loan Office 990 E. Washington Street, Suite F Sequim, WA 98382 Madison Park Loan Office 3101 E. Madison Street Seattle, WA 98112 2017 Owned 2013 Leased 2019(5) (1) Lease has one ten-year renewal option or lessee may choose two five-year renewal options. (2) Lease has one five-year renewal option. (3) Lease has two five-year renewal options. (4) Lease contains no renewal option. (5) Lease has one three-year renewal option. As of February 5, 2019, the renewal option was exercised extending the lease to 2022. We maintain depositor and borrower client files in a service bureau environment, utilizing a telecommunications network, portions of which are leased. Management has a disaster recovery plan in place with respect to the data processing system, as well as our operations as a whole. Item 3. Legal Proceedings From time to time we are involved as plaintiff or defendant in various legal actions arising in the normal course of business. We do not anticipate incurring any material legal fees or other material liability as a result of such litigation. Item 4. Mine Safety Disclosures Not applicable. 38 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities The common stock of Sound Financial Bancorp is traded on The NASDAQ Capital Market under the symbol ‘‘SFBC.’’ There were approximately 250 shareholders of record of our common stock as of March 12, 2019 Our cash dividend payout policy is reviewed regularly by management and the Board of Directors. Any dividends declared and paid in the future would depend upon a number of factors, including capital requirements, our financial condition and results of operations, tax considerations, statutory and regulatory limitations, and general economic conditions. No assurances can be given that any dividends will be paid or that, if paid, will not be reduced or eliminated in future periods. Our future payment of dividends may depend, in part, upon receipt of dividends from Sound Community Bank, which are restricted by federal regulations. Equity Compensation Plan Information The equity compensation plan information presented in Part III, Item 12 of this Form 10-K is incorporated herein by reference. Issuer Purchases of Equity Securities The Company may repurchase shares of its common stock from time-to-time in open market transactions. The timing, volume and price of purchases are made at our discretion, and are contingent upon our overall financial condition, as well as general market conditions. The Company did not make any stock repurchases during the fourth quarter of 2018 and as of December 31, 2018, the Company did not have any authorized stock repurchase programs. On January 28, 2019, the Company’s Board of Directors authorized a stock repurchase program. Under this repurchase program, the Company may repurchase up to $1,750,000 of the Company’s outstanding shares, in the open market, based on prevailing market prices, or in privately negotiated transactions, over a period beginning on January 31, 2019, continuing until the earlier of the completion of the repurchase or the next six (6) months, depending upon market conditions. The Company’s Board of Directors also authorized management to enter into a trading plan with a registered broker-dealer in accordance with Rule 10b5-1 of the Exchange Act, to facilitate repurchases of its common stock pursuant to the above mentioned stock repurchase program. 39 Item 6. Selected Financial Data SELECTED CONSOLIDATED FINANCIAL AND OTHER DATA The following table sets forth certain information concerning the Company’s consolidated financial position and results of operations at and for the dates indicated and have been derived from the audited consolidated financial statements. The information below is qualified in its entirety by the detailed information included elsewhere herein and should be read along with Item 7., ‘‘Management’s Discussion and Analysis of Financial Condition and Results of Operations’’ and Item 8., ‘‘Financial Statements and Supplementary Data.’’ (In thousands) Selected Financial Condition Data: Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total loans held for portfolio, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans held-for-sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Available for sale securities, at fair value . . . . . . . . . . . . . . . . . . . . . . . . Bank-owned life insurance, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other real estate owned and repossessed assets, net. . . . . . . . . . . . . . . . FHLB stock, at cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Selected Operations Data: Total interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net interest income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net interest income after provision for loan losses. . . . . . . . . . . . . . . . . Service charges and fee income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net gain on sale of loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mortgage servicing income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Earnings on cash surrender value of Bank Owned Life Insurance . . . . Other income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total noninterest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Salaries and benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operations expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Occupancy expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net losses and expenses on OREO and repossessed assets . . . . . . . . . . Other noninterest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total noninterest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before provision for income taxes . . . . . . . . . . . . . . . . . . . . . . . Provision for income taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . As of December 31, 2017 2016 2018 $716,735 613,769 1,172 4,957 13,365 575 4,134 553,601 84,000 $ 71,627 $645,244 543,354 1,777 5,435 12,750 610 3,065 514,400 59,000 $ 65,160 $588,383 495,179 871 6,604 12,082 1,172 2,840 467,731 54,792 $ 60,275 Year Ended December 31, 2017 2016 2018 $32,947 5,360 27,587 525 27,062 1,876 1,258 562 320 490 4,506 12,775 5,370 2,139 86 2,453 22,823 8,745 1,706 $27,449 3,368 24,081 500 23,581 1,895 1,071 566 327 — 3,859 10,733 4,348 1,889 110 2,167 19,247 8,193 3,068 $25,050 2,919 22,131 454 21,677 2,508 1,366 907 336 — 5,117 10,505 4,361 1,526 6 2,323 18,721 8,073 2,695 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,039 $ 5,125 $ 5,378 40 Selected Financial Ratios and Other Data: Performance ratios: Return on assets (ratio of net income to average total assets) . . . . . . . . Return on equity (ratio of net income to average equity) . . . . . . . . . . . Dividend payout ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest rate spread information: Average during period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . End of period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net interest margin(1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Noninterest income to total net revenue(2) . . . . . . . . . . . . . . . . . . . . . . . Noninterest expense to average total assets. . . . . . . . . . . . . . . . . . . . . . . Average interest-earning assets to average interest-bearing liabilities . . Efficiency ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Asset quality ratios: Nonperforming assets to total assets at end of period . . . . . . . . . . . . . . Nonperforming loans to total loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Allowance for loan losses to nonperforming loans. . . . . . . . . . . . . . . . . Allowance for loan losses to total loans . . . . . . . . . . . . . . . . . . . . . . . . . Net charge-offs to average loans outstanding . . . . . . . . . . . . . . . . . . . . . Capital ratios: Equity to total assets at end of period . . . . . . . . . . . . . . . . . . . . . . . . . . . Average equity to average assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other data: Number of full service offices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Year Ended December 31, 2017 2016 2018 1.03% 10.24 19.42 0.87% 8.13 29.37 0.97% 9.37 13.84 4.03 3.81 4.25 14.04 3.34 125.94 71.12 0.45 0.43 216.50 0.93 — 4.15 3.95 4.30 13.81 3.25 123.93 68.89 0.45 0.42 229.57 0.96 0.02 4.14 4.10 4.26 18.78 3.39 120.92 68.71 0.77 0.67 143.98 0.96 0.06 9.99 10.08% 10.10 10.64% 10.24 10.39% 8 7 6 (1) Net interest income divided by average interest earning assets. (2) Noninterest income divided by the sum of noninterest income and net interest income. 41 Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This discussion and analysis reviews our consolidated financial statements and other relevant statistical data and is intended to enhance your understanding of our financial condition and results of operations. The information in this section has been derived from the Consolidated Financial Statements and footnotes thereto that appear in Item 8 of this Form 10-K. The information contained in this section should be read in conjunction with these Consolidated Financial Statements and footnotes and the business and financial information provided in this Form 10-K. Overview Our principal business consists of attracting retail and commercial deposits from the general public and investing those funds, along with borrowed funds, in loans secured by first and second mortgages on one- to four-family residences (including home equity loans and lines of credit), commercial and multifamily real estate, construction and land, consumer and commercial business loans. Our commercial business loans include unsecured lines of credit and secured term loans and lines of credit secured by inventory, equipment and accounts receivable. We also offer a variety of secured and unsecured consumer loan products, including manufactured home loans, floating home loans, automobile loans, boat loans and recreational vehicle loans. As part of our business, we focus on residential mortgage loan originations, a portion of which we sell to Fannie Mae and the majority 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 released. 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. We originated $112.5 million, $109.7 million and $142.7 million of one- to four-family residential mortgage loans during the years ended December 31, 2018, 2017 and 2016, respectively. During these same periods, we sold $50.0 million, $52.0 million and $85.1 million, respectively, of one- to four-family residential mortgage loans. Our operating revenues are derived principally from earnings on interest earning assets, service charges and fees, and gains on the sale of loans. Our primary sources of funds are deposits, FHLB advances, and payments received on loans and securities. We offer a variety of deposit accounts that provide a wide range of interest rates and terms, including savings, money market, NOW, interest bearing and noninterest bearing demand accounts, and certificates of deposit. Our noninterest expenses consist primarily of salaries, medical benefits, incentive pay, commissions, and employee benefits, expenses for occupancy, online and mobile services, marketing, professional fees, data processing, charitable contributions, FDIC deposit insurance premiums and regulatory expenses. Salaries and benefits consist primarily of the salaries paid to our employees, payroll taxes, directors’ fees, retirement expenses, share-based compensation and other employee benefits. Occupancy expenses, which are the fixed and variable costs of buildings and equipment, consist primarily of lease payments, property taxes, depreciation charges, maintenance and the cost of utilities. Our strategic plan targets consumers, small and medium size businesses, and professionals in our market area for loans and deposits. In pursuit of these goals and by managing the size of our loan portfolio, we focus on including a significant amount of commercial business and commercial and multifamily real estate loans in our portfolio. A significant portion of these loans have adjustable rates, higher yields or shorter terms and higher credit risk than traditional fixed-rate mortgages. Our commercial loan portfolio (commercial and multifamily real estate and commercial business loans) increased to $291.4 million or 46.8% of our loan portfolio at December 31, 2018, from $252.1 million or 45.8% of our loan portfolio at December 31, 2017, and $207.3 million or 41.4% of our loan portfolio at December 31, 2016. In addition to higher balances in commercial lending, we also benefit from additional lending opportunities in our consumer loan portfolio. Our consumer loan portfolio, which includes manufactured and floating homes and other consumer loans, increased to 42 $67.6 million or 10.9% of our loan portfolio at December 31, 2018, from $51.1 million or 9.3% of our loan portfolio at December 31, 2017, and $43.4 million or 8.7% of our loan portfolio as of December 31, 2016. Additional commercial and multifamily real estate and consumer loans have improved our net interest income and helped diversify our loan portfolio mix. Our provision for loan losses expense was $525,000 for the year ended December 31, 2018, compared to $500,000 and $454,000 for the years ended December 31, 2017 and 2016, respectively. The increase in the provision for the year was primarily a result of the growth in loans held-for-portfolio, which increased 12.9% and 23.9% from December 31, 2017 and 2016, respectively. Recent Accounting Standards For a discussion of recent accounting standards, please see Note 2 - Accounting Pronouncements Recently Issued or Adopted in the Notes to Consolidated Financial Statements contained in Item 8 of this report on Form 10-K. Critical Accounting Policies Certain of our accounting policies are important to an understanding of our financial condition, since they 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. For additional information on our accounting policies see ‘‘Note 1 — Organization and Significant Accounting Policies’’ in the Notes to Consolidated Financial Statements contained in Item 8 of this report on Form 10-K. Allowance for Loan Loss. The allowance for loan losses is the amount estimated by management as necessary to cover losses inherent in the loan portfolio as of the balance sheet date. The allowance is established through the provision for loan losses, which is charged to income. Determining the amount of the allowance for loan losses necessarily involves a high degree of subjectivity and requires us to make various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans. Among the material estimates required to establish the allowance are: loss exposure at default; the amount and timing of future cash flows on impacted loans; value of collateral; and determination of historical and current loss factors to be applied to the various elements of the portfolio. All of these estimates are susceptible to significant change. Management reviews the level of the allowance at least quarterly and establishes the provision for loan losses based upon an evaluation of the portfolio, past loss experience, current economic conditions and other factors related to the collectability of the loan portfolio. To strengthen our loan review and classification process, we engage an independent consultant to review our classified loans and a significant sample of recently originated non-classified loans on a regular basis. We also enhanced our credit administration policies and procedures to improve our maintenance of updated financial data on commercial borrowers. 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. 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. Other-than-temporary impairment of securities. Management reviews investment securities on an ongoing basis for the presence of other-than-temporary impairment (‘‘OTTI’’), taking into consideration current market conditions; fair value in relationship to cost; extent and nature of the change in fair value; issuer rating changes and trends; whether management intends to sell a security or if it is likely that we will be required to sell the security before recovery of the amortized cost basis of the investment, which may be upon maturity; and other factors. For debt securities, if management intends to sell the security or it is likely that we will be required to sell the security before recovering our cost basis, the entire impairment loss would be recognized in earnings as 43 an OTTI. If management does not intend to sell the security and it is not more likely than not that we will be required to sell the security, but management does not expect to recover the entire amortized cost basis of the security, only the portion of the impairment loss representing credit losses would be recognized in earnings. The credit loss on a security is measured as the difference between the amortized cost basis and the present value of the cash flows expected to be collected. Projected cash flows are discounted by the original or current effective interest rate depending on the nature of the security being measured for potential OTTI. The remaining impairment related to all other factors, i.e., the difference between the present value of the cash flows expected to be collected and fair value, is recognized as a charge to other comprehensive income (loss). Impairment losses related to all other factors are presented as separate components within accumulated other comprehensive income (loss). Mortgage Servicing Rights. We record mortgage servicing rights on loans sold to Fannie Mae with servicing retained as well as for acquired servicing rights. We stratify our capitalized mortgage servicing rights based on the type, term and interest rates of the underlying loans. Mortgage servicing rights are carried at fair value. The value is determined through a discounted cash flow analysis, which uses interest rates, prepayment speeds and delinquency rate assumptions as inputs. All of these assumptions require a significant degree of management judgment. If our assumptions prove to be incorrect, the value of our mortgage servicing rights could be negatively impacted. We use a third party to assist us in the preparation of the analysis of the market value each quarter. Other Real Estate Owned. Other real estate owned (‘‘OREO’’) represents real estate that we have taken control of in partial or full satisfaction of significantly delinquent loans. At the time of foreclosure, OREO is recorded at the fair value less costs to sell, which becomes the property’s new basis. Any write-downs based on the asset’s fair value at the date of acquisition are charged to the allowance for loan and lease losses. After foreclosure, management periodically performs valuations such that the real estate is carried at the lower of its new cost basis or fair value, net of estimated costs to sell. Subsequent valuation adjustments are recognized within net (loss) gain on OREO. Revenue and expenses from operations and subsequent adjustments to the carrying amount of the property are included in other non-interest expense in the consolidated statements of income. In some instances, we may make loans to facilitate the sales of OREO. Management reviews all sales for which it is the lending institution for compliance with sales treatment under provisions established by ASC Topic 360, ‘‘Accounting for Sales of Real Estate’’. Any gains related to sales of OREO are deferred until the buyer has a sufficient initial and continuing investment in the property. Income Taxes. Income taxes are reflected in our financial statements to show the tax effects of the operations and transactions reported in the financial statements and consist of taxes currently payable plus deferred taxes. ASC Topic 740, ‘‘Accounting for Income Taxes,’’ requires the asset and liability approach for financial accounting and reporting for deferred income taxes. Deferred tax assets and liabilities result from differences between the financial statement carrying amounts and the tax bases of assets and liabilities. They are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled and are determined using the assets and liability method of accounting. The deferred income provision represents the difference between net deferred tax asset/liability at the beginning and end of the reported period. In formulating our deferred tax asset, we are required to estimate our income and taxes in the jurisdiction in which we operate. This process involves estimating our actual current tax exposure for the reported period together with assessing temporary differences resulting from differing treatment of items, such as depreciation and the provision for loan losses, for tax and financial reporting purposes. Valuation allowances are established to reduce the net carrying amount of deferred tax assets if it is determined to be more likely than not all or some portion of the potential deferred tax asset will not be realized. Business and Operating Strategies and Goals Our goal is to deliver returns to shareholders by increasing higher-yielding assets (including consumer, commercial and multifamily real estate and commercial business loans), increasing lower costing core deposit balances, managing expenses, managing problem assets and exploring expansion opportunities. We seek to achieve these results by focusing on the following objectives: Focusing on Asset Quality. We believe that strong asset quality is a key to our long-term financial success. We are focused on monitoring existing performing loans, resolving nonperforming assets and selling foreclosed assets. Nonperforming assets were $3.2 million, or 0.45% of total assets, at December 31, 2018 compared to 44 $2.9 million or 0.45% of total assets, at December 31, 2017. We continue to seek to reduce the level of non-performing assets through collections, modifications and sales of OREO. We also take proactive steps to resolve our non-performing loans, including negotiating payment plans, forbearances, loan modifications and loan extensions on delinquent loans when such actions have been deemed appropriate. Our goal is to maintain or improve upon our level of nonperforming assets by managing all segments of our loan portfolio in order to proactively identify and mitigate risk. Improving Earnings by Expanding Product Offerings. We intend to prudently maintain the percentage of our assets consisting of higher-yielding commercial and multifamily real estate and commercial business loans, which offer higher risk-adjusted returns, shorter maturities and more sensitivity to interest rate fluctuations than one- to four-family mortgage loans while maintaining our focus on residential lending. With our long experience and expertise in residential lending we believe we can be effective in capturing mortgage banking opportunities. We continue to develop correspondent relationships to sell nonconforming mortgage loans servicing-released. We also intend to selectively add additional products to further diversify revenue sources and to capture more of each client’s banking relationship by offering loan and deposit products and additional services to our clients. We intend to further build relationships with medium and small businesses through new and improving existing product offerings including remote deposit capture, online and mobile cash management, and online tools for wires, ACH and bill payment. Emphasizing lower cost core deposits to manage the funding costs of our loan growth. Our strategic focus is to emphasize total relationship banking with our clients to internally fund our loan growth. We also emphasize reducing wholesale funding sources, including FHLB advances, through the continued growth of core deposits. We believe that a continued focus on client relationships will help increase the level of core deposits and retail certificates of deposit from consumers and businesses in our market area. We intend to increase demand deposits by growing retail and business banking relationships. New technology and services are generally reviewed for business development and cost saving opportunities. We continue to experience growth in client use of our online and mobile banking services, which allow clients to conduct a full range of services on a real-time basis, including balance inquiries, transfers and electronic bill paying while providing our clients greater flexibility and convenience in conducting their banking. In addition to our retail branches, we maintain state of the art technology-based products, such as business cash management, business remote deposit products, business and consumer mobile banking applications and consumer remote deposit products. Total deposits increased to $553.6 million at December 31, 2018, from $514.4 million at December 31, 2017, and $467.7 million at December 31, 2016. At December 31, 2018, core deposits, which we define as our non-time deposit accounts and time deposit accounts of less than $250,000, increased $33.6 million to $500.9 million, while FHLB advances increased $25.0 million to $84.0 million from December 31, 2017. Maintaining Our Client Service Focus. Exceptional service, local involvement (including volunteering and contributing to the communities where we do business) and timely decision-making are integral parts of our business strategy. Our employees understand the importance of delivering exemplary customer service and seeking opportunities to build relationships with our clients to enhance our market position and add profitable growth opportunities. We compete with other financial service providers by relying on the strength of our customer service and relationship banking approach. We believe that one of our strengths is that our employees are also significant shareholders through our employee stock ownership (‘‘ESOP’’) and 401(k) plans. We also offer incentives that are designed to reward employees for achieving high quality client relationship growth. Expanding our presence within our existing and contiguous market areas and by capturing business opportunities resulting from changes in the competitive environment. We believe that opportunities currently exist within our market area to grow our franchise. We anticipate continued organic growth as the local economy and loan demand remains strong, through our marketing efforts and as a result of the opportunities created as a result of the consolidation of financial institutions that is occurring in our market area. In addition, by delivering high quality, client-focused products and services, we expect to attract additional borrowers and depositors and thus increase our market share and revenue generation. We continue to be disciplined as it pertains to future expansion, acquisitions and de novo branching focusing on the markets in Western Washington, which we know and understand. Comparison of Financial Condition at December 31, 2018 and December 31, 2017 General. Total assets increased by $71.5 million, or 11.1%, to $716.7 million at December 31, 2018 from $645.2 million at December 31, 2017. This increase was primarily the result of an increase in loans 45 held-for-portfolio, which increased $70.9 million or 12.9% compared to one year ago. Asset growth was funded by a $39.2 million, or 7.6%, increase in deposits and a $25.0 million, or 42.4%, increase in FHLB borrowings. Cash and Securities. Cash, cash equivalents and our available-for-sale securities increased $652,000, or 1.0%, to $66.8 million at December 31, 2018. Cash and cash equivalents increased $1.1 million, or 1.9%, to $61.8 million at December 31, 2018. Available-for-sale securities, which consist primarily of agency mortgage-backed securities, decreased $478,000, or 8.8%, to $5.0 million at December 31, 2018 from $5.4 million at December 31, 2017, primarily as a result of normal principal pay downs on investments during the year. At December 31, 2018, our securities portfolio consisted of six agency mortgage-backed securities and eight municipal securities with a fair value of $5.0 million. At December 31, 2017, our securities portfolio consisted of seven agency mortgage-backed securities and eight municipal bonds with a fair value of $5.4 million. During the year ended December 31, 2018 we did not recognize any non-cash OTTI charges on our investment securities. At December 31, 2018, three municipal securities had unrealized losses but management determined the decline in value was not related to specific credit deterioration. The unrealized losses were caused by changes in interest rates and the widening of market spreads subsequent to purchase of these securities. We do not intend to sell these securities and it is more likely than not that we will not be required to sell these securities before anticipated recovery of the remaining amortized cost basis. Loans. Our loans held for portfolio, net, excluding loans held-for-sale, increased $70.4 million, or 13.0%, to $613.8 million at December 31, 2018 from $543.4 million at December 31, 2017. Loans held-for-sale decreased to $1.2 million at December 31, 2018 from $1.8 million at December 31, 2017. The following table reflects the changes in the loan mix, excluding deferred fees, of our portfolio at the end of 2018, as compared to the end of 2017 (dollars in thousands): December 31, 2018 2017 Amount Change Percent Change One- to four-family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Home equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial and multifamily . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Construction and land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Manufactured homes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Floating homes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $169,830 27,655 252,644 65,259 20,145 40,806 6,628 38,804 $157,417 28,379 211,269 61,482 17,111 29,120 4,902 40,829 $12,413 (724) 41,375 3,777 3,034 11,686 1,726 (2,025) Total loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $621,771 $550,509 $71,262 7.9% (2.6) 19.6 6.1 17.7 40.1 35.2 (5.0) 12.9% All categories of our loan portfolio increased at December 31, 2018, compared to December 31, 2017, except for commercial business and home equity loans. The increase was primarily a result of positive economic conditions which contributed to demand for credit. The largest dollar increases in the loan portfolio were in the commercial and multifamily loans which increased $41.4 million, or 19.6%, to $252.6 million, one- to four-family loans which increased $12.4 million, or 7.9%, to $169.8 million, floating homes loans which increased $11.7 million, or 40.1%, to $40.8 million, and construction and land loans which increased $3.8 million, or 6.1%, to $65.3 million. Partially offsetting these increases were decreases in commercial business loans of $2.0 million, or 5.0%, to $38.8 million and home equity loans of $724,000, or 2.6%, to $27.7 million. The increase in our commercial and multifamily real estate loan portfolio was primarily a result of opportunities in the markets where we do business and an emphasis by our commercial lenders to originate these types of loans. Commercial and multifamily real estate loans are generally higher yielding loans and have contributed to diversifying our loan portfolio. We have also experienced appreciation in residential market prices and have a record low inventory of homes for sale due to continued strong demand. Floating and manufactured home loans increased as a result of increased demand for these types of loans by well-qualified borrowers coupled with less competition for these types of loans. The loan portfolio remains well-diversified with commercial and multifamily real estate loans accounting for 40.6% of the portfolio, one- to four-family real estate loans accounting for 27.3% of the portfolio and home equity, manufactured and floating homes, and other consumer loans accounting for 15.3% of the portfolio at December 31, 2018. Construction and land loans accounted for 46 10.6% of the portfolio and commercial business loans accounted for the remaining 6.2% of the portfolio at December 31, 2018. At December 31, 2017, commercial and multifamily real estate loans accounted for 38.4% of the portfolio, one- to four-family real estate loans accounted for 28.5% of the portfolio and home equity, manufactured homes, floating homes, and other consumer loans accounted for 14.5% of the portfolio, construction and land loans accounted for 11.2% of the portfolio and commercial business loans accounted for the remaining 7.4% of the portfolio. Mortgage Servicing Rights. At December 31, 2018 and 2017 both, we had $3.4 million in mortgage servicing rights recorded at fair value. We record mortgage servicing rights on loans sold to Fannie Mae with servicing retained and upon acquisition of a servicing portfolio. We stratify our capitalized mortgage servicing rights based upon the type, term and interest rates of the underlying loans. 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 December 31, 2018, our nonperforming assets totaled $3.2 million, or 0.45% of total assets, compared to $2.9 million, or 0.45% of total assets at December 31, 2017. The table below sets forth the amounts and categories of nonperforming assets in our loan portfolio at the dates indicated (dollars in thousands): Nonaccrual loans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Performing TDRs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . OREO and repossessed assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . December 31, 2018 $2,541 126 575 $3,242 2017 $2,149 134 610 $2,893 Amount Change $392 (8) (35) $349 Percent Change 18.2% (6.0) (5.7) 12.1% Nonperforming assets are comprised of nonaccrual loans, nonperforming TDRs, other real estate owned and other assets. The increase in nonperforming assets was principally due to an increase in nonaccrual loans of $392,000, or 18.2% and the reduction in OREO and repossessed assets of $35,000, or 5.7% as these assets were sold during the year. At December 31, 2018, eight TDRs totaling $691,000 were on nonaccrual, five were over 90 days past due totaling $387,000, one loan for $167,000 was 60-89 days past due and two loans totaling $137,000 were less than 60 days past due. Once a TDR has performed according to its modified terms for six months and the collection of principal and interest under the revised terms is deemed probable, we remove the TDR from nonaccrual status. Should a TDR, which was performing subsequently, become more than 30 days past due, we then consider it a nonperforming TDR. OREO and repossessed assets decreased 5.7% to $575,000 at December 31, 2018. OREO and repossessed assets at December 31, 2018 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. We sold one residential OREO property during 2018 with a net loss of $74,000. During 2017, we sold four personal residences at an aggregate net loss of $94,000 that were being held as OREO. There were no OREO sales in 2018. 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 incurred credit losses in our loan portfolio. 47 The following table reflects the adjustments in our allowance during 2018 and 2017 (dollars in thousands): Year Ended December 31, 2018 2017 Balance at beginning of period. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Charge-offs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Recoveries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,241 (50) 58 Net recoveries (charge-offs) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provisions charged to operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 525 $ 4,822 (143) 62 (81) 500 Balance at end of period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,774 $ 5,241 Ratio of net charge-offs during the period to average loans outstanding during the period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Allowance as a percentage of nonperforming loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Allowance as a percentage of total loans (end of period). . . . . . . . . . . . . . . . . . . . . . . . . . —% 216.50% 0.93% 0.02% 229.57% 0.96% Our allowance for loan losses increased $533,000, or 10.2%, to $5.8 million at December 31, 2018, from $5.2 million at December 31, 2017. The provision for loan losses totaled $525,000 for the year ended December 31, 2018 primarily as a result of the increase in loans held-for-portfolio and to a lesser extent the increase in non-performing loans as compared to December 31, 2017. Specific loan loss reserves decreased to $736,000 at December 31, 2018 compared to $1.1 million at December 31, 2017, while general loan loss reserves increased to $4.0 million at December 31, 2018, compared to $3.2 million at December 31, 2017 and the unallocated reserve increased to $1.0 million compared to $908,000 at December 31, 2017. The decrease in specific loan loss reserves was primarily due to improvement in financial performance for certain loans since December 31, 2017. The increase in the general reserve was a result of the changes in loan balances and historical loss rates. The overall increase in the allowance for loan losses was primarily due to an increase in loans held-for-portfolio to $619.5 million at December 31, 2018 from $548.6 million at December 31, 2017, and to a lesser extent the increase in non-performing loans. Loans individually evaluated for impairment decreased to $5.9 million at December 31, 2018, compared to $10.7 million at December 31, 2017. Net recoveries were $8,000 or 0.0% of average loans for the year ended December 31, 2018, compared to net charge-offs of $81,000 or 0.02% of average loans for the year ended December 31, 2017. At December 31, 2018, the allowance for loan losses as a percentage of total loans and nonperforming loans was 0.93% and 216.50%, respectively, compared to 0.96% and 229.57%, respectively, at December 31, 2017. Deposits. Total deposits increased $39.2 million, or 7.6%, to $553.6 million at December 31, 2018 from $514.4 million at December 31, 2017. The increase was primarily due to increases in noninterest-bearing demand deposits (including escrow accounts) of $23.9 million, or 33.2%, to $96.1 million at December 31, 2018 from $72.1 million at December 31, 2017 and certificates of deposit accounts which increased $27.3 million, or 16.6% to $191.8 million at December 31, 2018 from $164.6 million at December 31, 2017. These increases were partially offset by a $8.5 million, or 4.9%, decrease in interest-bearing demand accounts to $164.9 million at December 31, 2018 from $173.4 million at December 31, 2017, and a $8.2 million, or 14.9%, decrease in money market accounts to $46.7 million at December 31, 2018 from $54.9 million at December 31, 2017. The increase in noninterest-bearing demand accounts was primarily a result of our continued emphasis on attracting relatively low-cost core deposit accounts from small businesses and consumers. The increase in our total deposits at December 31, 2018 compared to December 31, 2017 reflects our continued focus on generating low cost deposits to support our loan growth. There were no brokered deposits outstanding at December 31, 2018 compared to $512,000 at December 31, 2017. 48 A summary of deposit accounts with the corresponding weighted-average cost at December 31, 2018 and 2017 is presented below (dollars in thousands): December 31, 2018 December 31, 2017 Noninterest-bearing demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest-bearing demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Savings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Money market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Certificates. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Escrow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amount $ 93,823 164,919 54,102 46,689 191,825 2,243 $553,601 Wtd. Avg. Rate Amount —% $ 69,094 173,413 49,450 54,860 164,554 3,029 0.71% $514,400 0.47 0.29 0.24 1.58 — Wtd. Avg. Rate —% 0.43 0.21 0.21 1.33 — 0.61% Borrowings. FHLB advances increased $25.0 million, or 42.4%, to $84.0 million at December 31, 2018, with a weighted-average cost of 2.72%, from $59.0 million at December 31, 2017, with a weighted-average cost of 1.63%. This increase in borrowings was a result of the growth in our loan portfolio. We rely on FHLB advances to fund interest-earning assets when deposits alone cannot fully fund interest-earning asset growth. This reliance on borrowings, rather than deposits, may increase our overall cost of funds. Stockholders’ Equity. Total stockholders’ equity increased $6.5 million, or 9.9%, to $71.6 million at December 31, 2018, from $65.2 million December 31, 2017. This increase primarily reflects net income of $7.0 million, stock-based compensation of $273,000, and ESOP share allocations of $421,000, partially offset by cash dividends of $1.4 million. 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). 2018 December 31, 2017 2016 Average Outstanding Balance Interest Earned/ Paid Yield/ Rate Average Outstanding Balance Interest Earned/ Paid Yield/ Rate Average Outstanding Balance Interest Earned/ Paid Yield/ Rate $589,205 $31,661 5.37% $508,520 $26,707 5.25% $474,356 $24,608 5.19% 60,628 649,833 1,286 32,947 2.12 5.07 51,747 560,267 742 27,449 1.43 4.90 45,613 519,969 442 25,050 0.97 4.82 Interest-earning assets: Loans(1) Investments and interest bearing . . . . . . . . . . . . . . . . . . accounts . . . . . . . . . . . . . . . . Total interest-earning assets(1) . . . Interest-bearing liabilities: Savings and money market accounts . . . . . . . . . . . . . . . . Demand and NOW accounts . . . . Certificate accounts . . . . . . . . . . Borrowings . . . . . . . . . . . . . . . . Total interest-bearing liabilities . . 100,639 170,518 174,922 69,900 515,979 200 874 2,765 1,521 5,360 0.20 0.51 1.58 2.18 101,717 163,009 157,575 29,791 1.04% 452,092 Net interest income . . . . . . . . . . $27,587 Net interest rate spread . . . . . . . . Net earning assets . . . . . . . . . . . $133,854 4.03% 4.25% $108,175 Net interest margin . . . . . . . . . . . Average interest-earning assets to average interest-bearing liabilities . . . . . . . . . . . . . . . . (1) Calculated net of deferred loan fees, loan discounts and loans in process. 49 164 744 2,113 347 3,368 $24,081 0.16 0.46 1.34 1.16 92,741 135,465 165,210 36,609 0.74% 430,025 4.15% 4.30% $ 89,944 147 529 2,032 211 2,919 $22,131 0.16 0.39 1.23 0.58 0.68 4.14% 4.26% 125.94% 123.93% 120.92% 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 the changes related to outstanding balances and that due to the changes in 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). Year Ended December 31, 2018 vs. 2017, Year Ended December 31 2017 vs. 2016 Increase (Decrease) due to Rate Volume Total Increase (Decrease) Increase (Decrease) due to Rate Volume Total Increase (Decrease) Interest-earning assets: Loans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investments and interest bearing accounts . . . . Total interest-earning assets . . . . . . . . . . . . . . Interest-bearing liabilities: Savings and Money Market accounts . . . . . . . . Demand and NOW accounts . . . . . . . . . . . . . . . Certificate accounts . . . . . . . . . . . . . . . . . . . . . . Borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,336 188 4,524 (2) 38 274 873 $618 356 974 38 92 378 301 Total interest-bearing liabilities . . . . . . . . . . . $1,183 $809 Change in net interest income . . . . . . . . . . . . . . $4,954 544 5,498 36 130 652 1,174 $1,992 $3,506 $1,794 88 1,882 14 126 (102) (79) $305 212 517 3 89 183 215 $ (41) $490 $2,099 300 2,399 17 215 81 136 $ 449 $1,950 Comparison of Results of Operation for the Years Ended December 31, 2018 and 2017 General. Net income increased $1.9 million to $7.0 million, or $2.74 per diluted common share for the year ended December 31, 2018, from $5.1 million, or $2.00 per diluted common share for the year ended December 31, 2017. The primary reasons for the increase in net income in 2018 compared to last year was due to higher net interest income and noninterest income and lower provision for income taxes, which were partially offset by higher noninterest expense. Income for the year ended December 31, 2018 was positively impacted by a $1.2 million decrease in tax expense due to tax rate changes, while the year ended December 31, 2017 was negatively impacted by $309,000 in tax expense related to an adjustment to the Company’s deferred tax asset from the tax rate changes. Interest Income. Total interest income increased by $5.5 million, or 20.0%, to $32.9 million for the year ended December 31, 2018, from $27.4 million for the year ended December 31, 2017. The increase in interest income for the year primarily reflects the increase in the average balance of interest-earning assets, in particular our average balance of loans held for portfolio and, to a lesser extent, a higher weighted-average yield on interest-earning assets during the year ended December 31, 2018 as compared to the prior year. Our weighted-average yield on interest-earning assets increased to 5.07% for the year ended December 31, 2018, compared to 4.90% for the year ended December 31, 2017. The weighted-average yield on loans increased 12 basis points to 5.37% for the year ended December 31, 2018 from 5.25% for the year ended December 31, 2017. The weighted-average yield on investments was 2.12%, compared to 1.43% for the year ended December 31, 2017. The increase in the average loan yield was due to the increase in market interest rates over the past year and the increase in the average balance of the loan portfolio. The average balance of loans portfolio increased $80.7 million, or 15.9%, for the year ended December 31, 2018 as compared to the prior year. The increase in the average outstanding balance in our loan portfolio compared to prior year was primarily a result of positive economic conditions which contributed to demand for credit. The average balance of available-for-sale securities 50 and interest-bearing accounts increased $8.9 million, or 17.2%, for the year ended December 31, 2018 as compared to the prior year. The increase in the average yields for all of our interest-earning assets for the year ended December 31, 2018 as compared to the prior year was due to the increase in market interest rates over the past year. Interest Expense. Interest expense increased $2.0 million, or 59.1%, to $5.4 million for the year ended December 31, 2018, from $3.4 million for the year ended December 31, 2017. This increase was primarily due to increases in both the average balance of and rates paid on deposits and FHLB advances. Our overall weighted-average cost of interest-bearing liabilities was 1.04% for the year ended December 31, 2018, compared to 0.74% for the year ended December 31, 2017. The rise in the cost of interest-bearing liabilities resulted from the increase in the targeted federal funds rate over the past year. Interest paid on deposits increased $818,000, or 27.1%, to $3.8 million for the year ended December 31, 2018, from $3.0 million for the year ended December 31, 2017, driven by an increase of $23.8 million, or 5.6% in the average balance of interest-bearing deposits to $446.1 million and a 10 basis points increase in the average rate paid on interest-bearing deposits for the year ended December 31, 2018. The average balance of total deposits increased $43.7 million to $537.2 million for the year ended December 31, 2018 as compared to $493.6 million for the same period in 2017. Our weighted-average cost of deposits was 0.71% during the year ended December 31, 2018 as compared to 0.61% during the prior year. The increase in average cost of deposits during the year ended December 31, 2018 was primarily a result of the increase in market interest rates. Interest expense on borrowings increased $1.2 million, or 338.3%, to $1.5 million for the year ended December 31, 2018 from $347,000 for the year ended December 31, 2017. The increase in interest expense on borrowings for the year ended December 31, 2018 was due to an increase in the average balance of borrowings and an increase in short-term interest rates from the rise in the targeted federal funds rate during the year. Average borrowings during the year ended December 31, 2018 were $69.9 million, compared to $29.8 million for the year ended December 31, 2017. The average cost of borrowings for the year ended December 31, 2018 increased to 2.18% compared to 1.16% for the year ended December 31, 2017. Net Interest Income. Net interest income increased $3.5 million, or 14.6%, to $27.6 million for the year ended December 31, 2018, from $24.1 million for the year ended December 31, 2017. The year over year increase primarily resulted from increased interest income due primarily to both higher average loan balances and higher yields on our loan portfolio, partially offset by increased interest expense. Our net interest margin was 4.25% for the year ended December 31, 2018, compared to 4.30% for the year ended December 31, 2017. The decrease was primarily due to higher funding costs as interest rates paid on interest-bearing liabilities increased more rapidly than yields earned on interest-earning assets. Provision for Loan Losses. We establish our allowance for loan losses through provisions for loan losses, which are charged to earnings, at a level 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 other qualitative factors. Large groups of smaller balance homogeneous loans, such as one- to four-family, commercial and multifamily real estate, home equity and consumer loans, including floating homes and manufactured homes, 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. We recorded a provision for loan losses of $525,000 for the year ended December 31, 2018, compared to $500,000 for the year ended December 31, 2017. The increase in the provision for the year was primarily a result of the growth in loans held for portfolio, which increased 12.9% from a year ago. Net loan recoveries were $8,000 for the year ended December 31, 2018, compared to net charge-offs of $81,000 for the year ended December 31, 2017. Nonperforming loans increased $384,000 during the year to $2.7 million at December 31, 2018, compared to a year ago. For the year ended December 31, 2018, the percentage of net recoveries/charge-offs to average loans outstanding was to 0.0% compared to 0.02% for the year ended December 31, 2017. Nonperforming loans to total loans increased slightly to 0.43% at December 31, 2018 from 0.42% at December 31, 2017. The allowance for loan 51 losses increased to $5.8 million at December 31, 2018 compared to $5.2 million at December 31, 2017. See ‘‘— Comparison of Financial Condition at December 31, 2018 and December 31, 2017 — Delinquencies and Nonperforming Assets’’ for more information on nonperforming loans in 2018. 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. 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 $647,000, or 16.8%, to $4.5 million for the year ended December 31, 2018, as compared to $3.9 million for the year ended December 31, 2017 as reflected below (dollars in thousands): Service charges and fee income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Earnings on cash surrender value of bank owned life insurance . . . Mortgage servicing income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net gain on sale of loans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total noninterest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . NM = not meaningful Year Ended December 31, 2018 $1,876 320 562 1,258 490 $4,506 2017 $1,895 327 566 1,071 — $3,859 Amount Change Percent Change $ (19) (7) (4) 187 490 $647 (1.0)% (2.1) (0.7) 17.5 NM 16.8% The increase in noninterest income from one year ago was primarily due to one-time proceeds of $490,000 from the gain on sale of Visa B Shares, included in other noninterest income, and a $187,000 increase in net gain on sale of loans, partially offset by a decrease in service charges and fees income. Noninterest Expense. Noninterest expense increased $3.6 million, or 18.6%, to $22.8 million for the year ended December 31, 2018, from $19.2 million for the year ended December 31, 2017, as reflected below (dollars in thousands): Year Ended December 31, 2018 2017 Amount Change Percent Change Salaries and benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Regulatory assessments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Occupancy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Data processing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Losses and expenses on OREO and repossessed assets. . . . . . . . . . . Total noninterest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,775 5,370 432 2,139 2,021 86 $22,823 $10,733 4,348 431 1,889 1,736 110 $19,247 $2,042 1,022 1 250 285 (24) $3,576 19.0% 23.5 0.2 13.2 16.4 (21.8) 18.6% The increase in noninterest expense from the year ended December 31, 2017 was primarily due to higher expense for salaries and benefits, operations and occupancy. Salaries and benefits expense increased $2.0 million compared to a year ago, primarily due to higher medical expenses, and an increase in the number of full-time equivalent employees (‘‘FTE’s’’) as a result of the addition of our University Place branch and loan production office in Sequim in 2017, as well as addition of our new Belltown branch in 2018. In addition, the percent of incentive bonuses paid out quarterly increased starting in January 2018, which also contributed to the year-over-year increase. Operations expense increased $1.0 million from a year ago, primarily due to an increase in audit fees, professional fees and loan related expenses. For the year ended December 31, 2018, compared to the prior year, occupancy expense increased $250,000, or 13.2%, due to a one-time adjustment to recognize straight-line rent expense over the life of a lease. 52 The efficiency ratio, which is noninterest expense as a percentage of net interest income and noninterest income, for the year ended December 31, 2018 was 71.12%, compared to 68.89% for the year ended December 31, 2017. The slight increase in the efficiency ratio compared to the prior year was primarily due to the increase in noninterest expense outpacing the increase in net interest income and noninterest income. Income Tax Expense. The provision for income taxes decreased $1.4 million, or 44.4% to $1.7 million for the year ended December 31, 2018, compared to $3.1 million for the year ended December 31, 2017. The decrease was primarily a result of the Tax Act, which impacted the Company positively in 2018 by reducing its statutory federal corporate income tax rate from 35% to 21%, and negatively in 2017 by requiring the Company to revalue its net deferred tax assets, resulting in a $309,000 adjustment through income tax expense in 2017. The effective tax rates for the years ended December 31, 2018 and 2017 were 19.5% and 38.4%, respectively. Liquidity Liquidity management is both a daily and longer-term function of management. Excess liquidity is generally invested in short-term investments, such as overnight deposits and federal funds. On a longer term basis, we maintain a strategy of investing in various loan products and investment securities, including mortgage-backed securities. We use our sources of funds primarily to meet ongoing commitments, pay maturing deposits, fund deposit withdrawals and fund loan commitments. We maintain cash and investments that qualify as liquid assets to maintain adequate liquidity to ensure safe and sound operations and meet demands for client funds (particularly withdrawals of deposits). At December 31, 2018, we had $66.8 million in cash and investment securities available for sale and $1.2 million in loans held-for-sale. We can also obtain funds from borrowings, primarily FHLB advances. At December 31, 2018, we had the ability to borrow an additional $156.0 million in FHLB advances, subject to certain collateral requirements and we had access to additional borrowings of $47.3 million through the Federal Reserve’s Discount Window, subject to certain collateral requirements. In addition, we also had available $21.0 million of credit facilities with other financial institutions, with no balance outstanding at December 31, 2018 or 2017. We are required to have adequate cash and investments that qualify as liquid assets in order to maintain sufficient liquidity to ensure safe and sound operations. Liquidity may increase or decrease depending upon the availability of funds and comparative yields on investments in relation to the return on loans. Historically, we have maintained liquid assets above levels believed to be adequate to meet the requirements of normal operations, including potential deposit outflows. Cash flow projections are regularly reviewed and updated to assure that adequate liquidity is maintained. Liquidity management involves the matching of cash flow requirements of clients, who may be either depositors desiring to withdraw funds or borrowers needing assurance that sufficient funds will be available to meet their credit needs and our ability to manage those requirements. We strive to maintain an adequate liquidity position by managing the balances and maturities of interest-earning assets and interest-bearing liabilities so that the balance we have in short-term investments at any given time will adequately cover any reasonably anticipated, immediate need for funds. Additionally, we maintain relationships with correspondent banks, which could provide funds on short-term notice if needed. Our liquidity, represented by cash and cash-equivalents, is a product of our operating, investing and financing activities. As disclosed in our Consolidated Statements of Cash Flows in Item 8 of this Annual Report on Form 10-K, cash and cash equivalents increased $1.1 million to $61.8 million as of December 31, 2018, from $60.7 million at December 31, 2017. Net cash provided by operating activities was $10.3 million for the year ended December 31, 2018. Net cash of $71.5 million was used in investing activities for the year ended December 31, 2018 and consisted principally of loan originations, net of principal repayments. There was $62.3 million of cash provided by financing activities for the year ended December 31, 2018 which primarily consisted of a $39.2 million increase in deposits and a $25.0 million net increase in FHLB advances. Sound Financial Bancorp is a separate legal entity from Sound Community Bank and must provide for its own liquidity. In addition to its own operating expenses (many of which are paid to Sound Community Bank), Sound Financial Bancorp is responsible for paying any dividends declared to its shareholders, and interest and principal on outstanding debt. Sound Financial Bancorp’s primary source of funds is dividends from Sound Community Bank, which are subject to regulatory limits. At December 31, 2018 Sound Financial Bancorp, on an unconsolidated basis, had $18,000 in cash, noninterest-bearing deposits and liquid investments generally available for its cash needs. 53 Our liquidity, represented by cash and cash equivalents and investment securities, is a product of our operating, investing and financing activities. Our primary sources of funds are deposits, amortization, prepayments and maturities of outstanding loans and mortgage-backed securities, maturities of investment securities and other short-term investments and funds provided from operations. While scheduled payments from the amortization of loans and mortgage-backed securities and maturing investment securities and short-term investments are relatively predictable sources of funds, deposit flows and loan prepayments are greatly influenced by general interest rates. We also generate cash through borrowings. We utilize FHLB advances to leverage our capital base and provide funds for our lending and investment activities, and to enhance our interest rate risk management. We use our sources of funds primarily to meet ongoing commitments, pay maturing deposits and fund withdrawals, and to fund loan commitments. At December 31, 2018, the approved outstanding loan commitments, including unused lines and letters of credit, amounted to $110.6 million. Certificates of deposit scheduled to mature in one year or less at December 31, 2018, totaled $110.7 million. It is management’s policy to offer deposit rates that are competitive with other local financial institutions. Based on this management strategy, we believe that a majority of maturing deposits will remain with us. See also the Consolidated Statements of Cash Flows, included in Item 8, ‘‘Financial Statements and Supplementary Data,’’ of this Form 10-K, for further information. 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 clients’ requests for funding and take the form of loan commitments and lines of credit. For the year ended December 31, 2018, we did not engage in any off-balance sheet transactions likely to have a material effect on our financial condition, results of operations or cash flows. A summary of our off-balance sheet loan commitments at December 31, 2018, is as follows (in thousands): Off-balance sheet loan commitments: Residential mortgage commitments. . . . . . . . . . Unfunded construction commitments . . . . . . . . Unused lines of credit . . . . . . . . . . . . . . . . . . . . Irrevocable letters of credit . . . . . . . . . . . . . . . . Amount $ 3,176 60,632 45,315 1,460 Total loan commitments. . . . . . . . . . . . . . . . . $110,583 Capital Sound Community Bank is subject to minimum capital requirements imposed by regulations of the FDIC. Based on its capital levels at December 31, 2018, Sound Community Bank exceeded these requirements as of that date. Consistent with our goals to operate a sound and profitable organization, our policy is for Sound Community Bank to maintain a ‘‘well-capitalized’’ status under the regulatory capital categories of the FDIC. Based on capital levels at December 31, 2018, Sound Community Bank was considered to be well-capitalized. Management monitors the capital levels to provide for current and future business opportunities and to maintain Sound Community Bank’s ‘‘well-capitalized’’ status. For additional details see Note 15 in the Notes to Consolidated Financial Statements contained in ‘‘Item 8. Financial Statements and Supplementary Data’’ and ‘‘Item 1. ‘‘Business — How We Are Regulated — Regulation of Sound Community Bank — Capital Rules’’ of this Form 10-K. 54 The following table shows the capital ratios of Sound Community Bank at December 31, 2018 (dollars in thousands): Actual Minimum Capital Requirements Amount Ratio Amount Ratio Minimum Required to be Well-Capitalized Under Prompt Corrective Action Provisions Amount Ratio Tier 1 Capital to average total adjusted assets(1) . . . . Common Equity Tier 1 to risk-weighted assets(2) . . . Tier 1 Capital to risk-weighted assets(2) . . . . . . . . . . . Total Capital to risk-weighted assets(2) . . . . . . . . . . . . $69,685 69,685 69,685 $75,874 9.73% $28,659 26,665 11.76 11.76 35,553 12.80% $47,404 4.0% $35,824 38,516 4.5 6.0 47,404 8.0% $59,255 5.0% 6.5 8.0 10.0% (1) Based on total adjusted assets of $716,475 at December 31, 2018. (2) Based on risk-weighted assets of $592,551 at December 31, 2018. 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 December 31, 2018, Sound Financial Bancorp would have exceeded all regulatory capital requirements. The estimated regulatory capital ratios calculated for Sound Financial Bancorp as of December 31, 2018 were 9.85% for Tier 1 Capital to total adjusted assets, 11.92% for both Common Equity Tier 1 risk-based capital, and Tier 1 Capital to risk-based assets and 12.96% for total risk-based capital. 55 Item 7A. Quantitative and Qualitative Disclosures About Market Risk Asset/Liability Management Our Risk When Interest Rates Change. The rates of interest we earn on assets and pay on liabilities generally are established contractually for a period of time. Market rates change over time. Like other financial institutions, our results of operations are impacted by changes in interest rates and the interest rate sensitivity of our assets and liabilities. The risk associated with changes in interest rates and our ability to adapt to these changes is known as interest rate risk and is our most significant market risk. How We Measure Our Risk of Interest Rate Changes. As part of efforts to manage our exposure to changes in interest rates and comply with applicable regulations, we monitor our interest rate risk. In doing so, we analyze and manage assets and liabilities based on their interest rates and payment streams, timing of maturities, re-pricing opportunities, and sensitivity to actual or potential changes in market interest rates. We are subject to interest rate risk to the extent that our interest-bearing liabilities, primarily deposits and FHLB advances, re-price more rapidly or at different rates than our interest-earning assets. In order to minimize the potential for adverse effects of material prolonged increases or decreases in interest rates on our results of operations, we have adopted an asset and liability management policy. Our Board of Directors approves the asset and liability policy, which is implemented by the asset/liability committee. The purpose of the asset/liability committee is to communicate, coordinate, and control asset/liability management consistent with our business plan and board-approved policies. The committee establishes and monitors the volume and mix of assets and funding sources, taking into account relative costs and spreads, interest rate sensitivity and liquidity needs. The objectives are to manage assets and funding sources to produce results that are consistent with liquidity, capital adequacy, growth, risk and profitability goals. The committee generally meets monthly to, among other things, protect capital through earnings stability over the interest rate cycle; maintain our well-capitalized status; and provide a reasonable return on investment. The committee recommends appropriate strategy changes based on this review. The committee is responsible for reviewing and reporting the effects of the policy implementations and strategies to the board of directors at least quarterly. Senior managers oversee the process on a daily basis. A key element of our asset/liability management plan is to protect net earnings by managing the maturity or re-pricing mismatch between our interest-earning assets and our rate-sensitive liabilities. We seek to reduce exposure to earnings by extending funding maturities through the use of FHLB advances, through the use of adjustable rate loans and through the sale of certain fixed rate loans in the secondary market. As part of our efforts to monitor and manage interest rate risk, we maintain an interest rate risk model and utilize software and resources provided by a third party. The model contains several assumptions that are based upon a combination of proprietary and market data that reflect historical results and current market conditions. These assumptions relate to interest rates, prepayments, deposit decay rates and the market value of certain assets under the various interest rate scenarios. The model’s capital at risk measure, also known as the Economic Value of Equity (‘‘EVE’’), evaluates the change in the projected EVE over a two-year period given an immediate increase or decrease in interest rates. It considers both the absolute dollar change in EVE and also the percentage change in EVE. Management and the Board of Directors review these measurements on a quarterly basis to determine whether our interest rate exposure is within the limits established by the Board of Directors. Our asset/liability management strategy dictates acceptable limits on the amounts of change in given changes in interest rates. For interest rate increases of 100, 200, 300 and 400 basis points, our policy dictates that our EVE percentage change should not decrease greater than 10%, 20%, 25% and 30%, respectively and that our EVE ratio not fall below 9%, 8%, 6% and 5%, respectively. As illustrated in the table below, we were in compliance with this aspect of our asset/liability management policy at December 31, 2018. The table presented below, at December 31, 2018, is an internal analysis of our interest rate risk as measured by changes in EVE for instantaneous and sustained parallel shifts in the yield curve, in 100 basis point increments, up 400 basis points and down 200 basis points. Given that the current targeted Federal Funds Rate is a range of 2.25 to 2.50%, a 300 basis point reduction in rates is not reported. As illustrated in the table below (dollars in thousands), our EVE would be negatively impacted by an increase in interest rates of 400 basis points or a decrease in interest rates of 100 and 200 basis points. Our EVE is impacted 56 as a result of deposit accounts re-pricing more rapidly than loans and securities due to the fixed rate nature of a large portion of our loan and security portfolios. As interest rates increase, the market value of our fixed rate assets decline due to both rate increases and slowing prepayments. Change in Interest Rates in Basis Points (bps) +400 +300 +200 +100 0 -100 -200 December 31, 2018 Economic Value of Equity $ Change $ (385) 1,379 2,290 1,897 — (3,102) $(12,633) $ Amount $91,450 93,214 94,125 93,732 91,835 88,733 $79,203 % Change (0.42)% 1.50 2.49 2.07 — (3.38) (13.76)% EVE Ratio % 13.84% 13.86 13.76 13.47 12.97 12.34 10.84% In addition to monitoring selected measures of EVE, management also monitors effects on net interest income resulting from increases or decrease in rates. This process is used in conjunction with EVE measures to identify excessive interest rate risk. In managing our assets/liability mix, depending on the relationship between long- and short-term interest rates, market conditions and consumer preference, we may place somewhat greater emphasis on maximizing our net interest margin than on strictly matching the interest rate sensitivity of assets and liabilities. Management also believes that the increased net income which may result from an acceptable mismatch in the actual maturity or re-pricing of its asset and liability portfolios can, during periods of declining or stable interest rates, provide sufficient returns to justify the increased exposure to sudden and unexpected increases in interest rates which may result from such a mismatch. Management believes that our level of interest rate risk is acceptable under this approach. In evaluating our exposure to interest rate movements, certain shortcomings inherent in the method of analysis presented in the foregoing table must be considered. For example, although certain assets and liabilities may have similar maturities or re-pricing periods, they may react in different degrees to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in interest rates. Additionally, certain assets, such as adjustable rate mortgages, have features which restrict changes in interest rates on a short-term basis and over the life of the asset. Further, in the event of a significant change in interest rates, prepayment and early withdrawal levels would likely deviate significantly from those assumed above. Finally, the ability of many borrowers to service their debt may decrease in the event of an interest rate increase. We consider all of these factors in monitoring our exposure to interest rate risk. 57 Item 8. Financial Statements and Supplementary Data Report of Independent Registered Public Accounting Firm To the Shareholders and the Board of Directors of Sound Financial Bancorp, Inc. Opinions on the Financial Statements and Internal Control over Financial Reporting We have audited the accompanying consolidated balance sheets of Sound Financial Bancorp, Inc. and Subsidiary (the ‘‘Company’’) as of December 31, 2018 and 2017, the related consolidated statements of income, comprehensive income, stockholders’ equity and cash flows for the years then ended, and the related notes (collectively referred to as the ‘‘consolidated financial statements’’). We also have audited the Company’s internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company as of December 31, 2108 and 2017, and the consolidated results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control - Integrated Framework (2013) issued by COSO. Basis for Opinions The Company’s management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management Report on Internal Control over Financial Reporting included in Item 9A. Our responsibility is to express an opinion on the Company’s consolidated financial statements and an opinion on the Company’s internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (‘‘PCAOB’’) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the consolidated financial statements included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures to respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. Definition and Limitations of Internal Control Over Financial Reporting A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance 58 with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. /s/ Moss Adams, LLP Everett, Washington March 14, 2019 We have served as the Company’s auditor since 2002. 59 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Consolidated Balance Sheets (In thousands, except share and per share amounts) ASSETS Cash and cash equivalents. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Available-for-sale securities, at fair value. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans held-for-sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans held for portfolio. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Allowance for loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total loans held for portfolio, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bank-owned life insurance, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other real estate owned (‘‘OREO’’) and repossessed assets, net . . . . . . . . . . . . . . . Mortgage servicing rights, at fair value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal Home Loan Bank (‘‘FHLB’’) stock, at cost . . . . . . . . . . . . . . . . . . . . . . . . . Premises and equipment, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . December 31, 2018 2017 $ 61,810 4,957 1,172 619,543 (5,774) 613,769 2,287 13,365 575 3,414 4,134 7,044 4,208 $ 60,680 5,435 1,777 548,595 (5,241) 543,354 1,977 12,750 610 3,426 3,065 7,392 4,778 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $716,735 $645,244 LIABILITIES Deposits Interest-bearing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Noninterest-bearing demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Advance payments from borrowers for taxes and insurance . . . . . . . . . . . . . . . . . . . Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $457,535 96,066 553,601 84,000 137 6,681 689 645,108 $442,277 72,123 514,400 59,000 77 5,972 635 580,084 COMMITMENTS AND CONTINGENCIES (NOTE 7 and 17) STOCKHOLDERS’ EQUITY Preferred stock, $0.01 par value, 10,000,000 shares authorized, none issued or outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — — Common stock, $0.01 par value, 40,000,000 shares authorized, 2,544,059 and 2,511,127 issued and outstanding as of December 31, 2018 and 2017, respectively. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unearned shares - Employee Stock Ownership Plan (‘‘ESOP’’). . . . . . . . . . . . . . . . Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated other comprehensive income, net of tax . . . . . . . . . . . . . . . . . . . . . . . Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 25,663 (340) 46,165 114 71,627 25 24,986 (453) 40,493 109 65,160 Total liabilities and stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $716,735 $645,244 See notes to consolidated financial statements 60 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Consolidated Statements of Income (In thousands, except share and per share amounts) INTEREST INCOME Loans, including fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest and dividends on investments, cash and cash equivalents . . . . . . . . . . . . $ Total interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . INTEREST EXPENSE Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . PROVISION FOR LOAN LOSSES Net interest income after provision for loan losses . . . . . . . . . . . . . . . . . . . . . . . . NONINTEREST INCOME Service charges and fee income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Earnings on cash surrender value of bank-owned life insurance . . . . . . . . . . . . . Mortgage servicing income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net gain on sale of loans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total noninterest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . NONINTEREST EXPENSE Salaries and benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Occupancy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Data processing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Regulatory assessments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net loss and expenses on OREO and repossessed assets . . . . . . . . . . . . . . . . . . . Total noninterest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before provision for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Earnings per common share: Year Ended December 31, 2018 2017 31,661 1,286 32,947 3,839 1,521 5,360 27,587 525 27,062 1,876 320 562 1,258 490 4,506 12,775 5,370 2,139 2,021 432 86 22,823 8,745 1,706 7,039 $ 26,707 742 27,449 3,021 347 3,368 24,081 500 23,581 1,895 327 566 1,071 — 3,859 10,733 4,348 1,889 1,736 431 110 19,247 8,193 3,068 5,125 Basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ 2.82 2.74 $ $ 2.05 2.00 Weighted average number of common shares outstanding: Basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,498,161 2,567,165 2,504,430 2,568,082 See notes to consolidated financial statements 61 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Consolidated Statements of Comprehensive Income (In thousands) Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Available for sale securities: Unrealized gains arising during the year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax expense related to unrealized gains/losses . . . . . . . . . . . . . . . . . . . . . . . . . . Other comprehensive income, net of tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Year Ended December 31, 2018 $7,039 2017 $5,125 7 (2) 5 43 (15) 28 Comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $7,044 $5,153 See notes to consolidated financial statements 62 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Consolidated Statements of Stockholders’ Equity (In thousands, except share and per share amounts) Common Stock Additional Paid-in Capital Unearned ESOP Shares Retained Earnings Shares Balance at December 31, 2016. . . . 2,498,804 Net income . . . . . . . . . . . . . . . . . . . Other comprehensive loss, net of $25 $23,979 $(683) $36,873 5,125 tax . . . . . . . . . . . . . . . . . . . . . . . . Share-based compensation . . . . . . . Restricted stock awards . . . . . . . . . Cash dividends on common stock ($0.60 per share) . . . . . . . . . . . . . Common stock repurchased . . . . . . Common stock options exercised. . Allocation of ESOP shares . . . . . . . 576 (3,353) 15,100 523 43 441 230 (1,505) Accumulated Other Comprehensive Income, net of tax $ 81 28 Total Stockholders’ Equity $60,275 5,125 28 523 — (1,505) — 43 671 Balance at December 31, 2017. . . . 2,511,127 $25 $24,986 $(453) $40,493 $109 $65,160 Common Stock Additional Paid-in Capital Unearned ESOP Shares Retained Earnings Shares Balance at December 31, 2017. . . . 2,511,127 Net income . . . . . . . . . . . . . . . . . . . Other comprehensive income, net $25 $24,986 $(453) $40,493 7,039 of tax . . . . . . . . . . . . . . . . . . . . . . Share-based compensation . . . . . . . Restricted stock awards . . . . . . . . . Cash dividends on common stock ($0.54 per share) . . . . . . . . . . . . . Common stock repurchased . . . . . . Restricted shares forfeited . . . . . . . Common stock options exercised. . Allocation of ESOP shares . . . . . . . 323 (16,314) (343) 49,266 (22) 273 118 308 113 (1,367) Accumulated Other Comprehensive Income, net of tax $109 5 Total Stockholders’ Equity $65,160 7,039 (17) 273 — (1,367) — — 118 421 Balance at December 31, 2018. . . . 2,544,059 $25 $25,663 $(340) $46,165 $114 $71,627 See notes to consolidated financial statements 63 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Consolidated Statements of Cash Flows (In thousands) CASH FLOWS FROM OPERATING ACTIVITIES: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjustments to reconcile net income to net cash from operating activities: Amortization (accretion) of net premiums/discounts on investments . . . . . . . . . . Provision for loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation and amortization. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Compensation expense related to stock options and restricted stock . . . . . . . . . . Change in fair value of mortgage servicing rights. . . . . . . . . . . . . . . . . . . . . . . . . Increase in cash surrender value of BOLI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net change in advances from borrowers for taxes and insurance . . . . . . . . . . . . . Deferred income tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net gain on sale of loans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from sale of loans held-for-sale. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Originations of loans held-for-sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net loss on OREO and repossessed assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Change in operating assets and liabilities: Accrued interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash provided by operating activities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . CASH FLOWS FROM INVESTING ACTIVITIES: Proceeds from principal payments, maturities and sales of available for sale securities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net increase in loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchase of BOLI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from sale of OREO and other repossessed assets . . . . . . . . . . . . . . . . . Purchases of premises and equipment, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash received from branch acquisition. . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash used in investing activities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . CASH FLOWS FROM FINANCING ACTIVITIES Net increase in deposits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from borrowings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Repayment of borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FHLB stock purchased . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ESOP shares released. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from common stock option exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends paid on common stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash provided by financing activities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net increase in cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash and cash equivalents, beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash and cash equivalents, end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Year Ended December 31, 2018 2017 $ 7,039 $ 5,125 41 525 989 273 513 (320) 54 69 (1,258) 49,341 (47,979) 74 (310) 505 60 709 10,325 416 (70,995) (295) 16 (641) — (71,499) (2) 500 943 523 135 (327) (3) 106 (1,071) 51,959 (51,794) 94 (161) (305) 4 1,098 6,824 1,214 (48,651) (341) 468 (2,474) 13,671 (36,113) 39,201 262,000 (237,000) (1,069) 421 118 (1,367) 62,304 1,130 60,680 $ 61,810 32,195 229,000 (224,792) (225) 671 43 (1,505) 35,387 6,098 54,582 $ 60,680 SUPPLEMENTAL CASH FLOW INFORMATION Cash paid for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest paid on deposits and borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Noncash net transfer from loans to OREO and repossessed assets. . . . . . . . . . Acquired assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Assumed liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ 2,670 5,300 55 — — $ 2,460 3,364 — 803 $ 14,474 See notes to consolidated financial statements 64 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Note 1 - Organization and significant accounting policies Sound Financial Bancorp, a Maryland corporation (‘‘Sound Financial Bancorp’’ or the ‘‘Company’’), is a bank holding company for its wholly owned subsidiary, Sound Community Bank (the ‘‘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 State Department of Financial Institutions (‘‘WDFI’’) and the Federal Deposit Insurance Corporation (‘‘FDIC’’). The Board of Governors of the Federal Reserve System (‘‘Federal Reserve’’) is the primary federal regulator for Sound Financial Bancorp. The Company’s business activities generally are limited to passive investment activities and oversight of its investment in the Bank. Accordingly, the information set forth in this report relates primarily to the Bank. Subsequent events – The Company has evaluated subsequent events for potential recognition and disclosure. Basis of Presentation and Use of Estimates – The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of income and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, the fair value of mortgage servicing rights, valuations of impaired loans and OREO, and the realization of deferred taxes. The accompanying consolidated financial statements include the accounts of Sound Financial Bancorp and its wholly-owned subsidiary Sound Community Bank. All significant intercompany balances and transactions between Sound Financial Bancorp and its subsidiary have been eliminated in consolidation. Cash and cash equivalents – For purposes of reporting cash flows, cash and cash equivalents include cash on hand and in banks and interest-bearing deposits. All have original maturities of three months or less and may exceed federally insured limits. Investment securities – Investment securities are classified into one of three categories: (1) held-to-maturity, (2) available-for-sale (‘‘AFS’’), or (3) trading. The Company had no held-to-maturity or trading securities at December 31, 2018 or 2017. AFS securities consist of debt securities that the Company has the intent and ability to hold for an indefinite period, but not necessarily to maturity. Such securities may be sold to implement the Company’s asset/liability management strategies and/or in response to changes in interest rates and similar factors. AFS securities are reported at fair value. Dividend and interest income are recognized when earned. Unrealized gains and losses, net of the related deferred tax effect, are reported as a net amount in accumulated other comprehensive income (loss) on AFS securities in the consolidated balance sheets. Realized gains and losses on AFS securities, determined using the specific identification method, are included in earnings. Amortization of premiums and accretion of discounts are recognized as adjustments to interest income using the interest method over the period to maturity. The Company reviews investment securities on an ongoing basis for the presence of other-than-temporary impairment (‘‘OTTI’’) or permanent impairment, taking into consideration current market conditions, fair value in relation to cost, extent and nature of the change in fair value, issuer rating changes and trends, whether the Company intends to sell a security or if it is likely that the Company will be required to sell the security before recovery of its amortized cost basis of the investment, which may be maturity, and other factors. For debt securities, if the Company intends to sell the security or it is likely that it will be required to sell the security before recovering its cost basis, the entire impairment loss would be recognized in earnings as an OTTI. If the Company does not intend to sell the security and it is not likely that we will be required to sell the security but we do not expect to recover the entire amortized cost basis of the security, only the portion of the impairment loss representing credit losses would be recognized in earnings. The credit loss on a security is measured as the difference between the amortized cost basis and the present value of the cash flows expected to be collected. Projected cash flows are discounted by the original or current effective interest rate depending on the nature of the security being measured for potential OTTI. 65 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements The remaining impairment related to all other factors, the difference between the present value of the cash flows expected to be collected and the fair value, is recognized as a charge to other comprehensive income (‘‘OCI’’). The Company does not intend to sell these securities and it is more likely than not that it will not be required to sell the securities before anticipated recovery of the remaining amortized cost basis. The Company closely monitors its investment securities for changes in credit risk. The current market environment significantly limits the Company’s ability to mitigate its exposure to valuation changes in these securities by selling them. Accordingly, if market conditions deteriorate further and the Company determines its holdings of these or other investment securities are OTTI, its future earnings, stockholders’ equity, regulatory capital and continuing operations could be materially adversely affected. Loans held-for-sale – To mitigate interest rate sensitivity, from time to time, certain fixed rate mortgage loans are identified as held-for-sale in the secondary market. Accordingly, such loans are classified as held-for-sale in the consolidated balance sheets and are carried at the lower of cost or estimated fair market value in the aggregate. Net unrealized losses, if any, are recognized through a valuation allowance by charges to income. Mortgage loans held-for-sale are generally sold with the mortgage servicing rights retained by the Company. Gains or losses on sales of loans are recognized based on the difference between the selling price and the carrying value of the related loans sold based on the specific identification method. Loans – The Company grants mortgage, commercial, and consumer loans to clients. A substantial portion of the loan portfolio is represented by loans secured by real estate located throughout the Puget Sound region, especially King, Snohomish and Pierce Counties, and in Clallam and Jefferson Counties of Washington State. The ability of the Company’s debtors to honor their contracts is dependent upon employment, real estate and general economic conditions in these areas. Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are reported at their outstanding unpaid principal balance adjusted for any charge-offs, allowance for loan losses, and any deferred fees or costs on origination of loans. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized as an adjustment of the related loan yield using the interest method over the contractual life of the loan for term loans or the straight-line method for open ended loans. The accrual of interest is discontinued at the time the loan is 90 days past due or if, in management’s opinion, the borrower may be unable to meet payment of obligations as they become due, as well as when required by regulatory provisions. Loans are typically charged off no later than 120 days past due, unless secured by collateral. Past due status is based on contractual terms of the loan. In all cases, loans are placed on nonaccrual or charged off at an earlier date if collection of principal or interest is considered doubtful. All interest accrued but not collected for loans that are placed on nonaccrual or charged-off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all of the principal and interest amounts contractually due are brought current, future payments are reasonably assured and payments have been received for twelve consecutive months. A loan is considered impaired when it is probable that the Company will be unable to collect all amounts (principal and interest) due according to the contractual terms of the original loan agreement. When a loan has been identified as being impaired, the amount of the impairment is measured by using discounted cash flows, except when, as a practical expedient, the current fair value of the collateral, reduced by costs to sell, is used. When the measurement of the impaired loan is less than the recorded investment in the loan (including accrued interest), impairment is recognized by charging off the impaired portion or creating or adjusting a specific allocation of the allowance for loan losses. A loan is classified as a troubled debt restructuring (‘‘TDR’’) when certain concessions have been made to the contractual terms, such as reductions of interest rates or deferrals of interest or principal payments due to the borrower’s deteriorated financial condition. All TDRs are reported and accounted for as impaired loans. Allowance for loan losses – The allowance for loan losses is a reserve established through a provision for loan losses charged to expense and represents management’s best estimate of probable losses incurred within the 66 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements existing loan portfolio as of the balance sheet date. The level of the allowance reflects management’s view of trends in loan loss activity, current loan portfolio quality and present economic, political and regulatory conditions. Portions of the allowance may be allocated for specific loans; however, the allowance is available for any loan that is charged off. The allowance is increased by provisions charged to earnings and by recoveries of amounts previously charged off, and is reduced by charge-offs on loans (or portions thereof) deemed to be uncollectible. Loan charge-offs are recognized when management believes the collectability of the principal balance outstanding is unlikely. Full or partial charge-offs on collateral dependent impaired loans are generally recognized when the collateral is deemed to be insufficient to support the carrying value of the loan. The allowance for loan losses is maintained at a level sufficient to provide for probable credit losses based upon evaluating known and inherent risks in the loan portfolio. The allowance is provided based upon management’s continuing analysis of the pertinent factors underlying the quality of the loan portfolio. These factors include changes in the size and composition of the loan portfolio, delinquency levels, actual loan loss experience, current economic conditions, and detailed analysis of individual loans for which full collectability may not be assured. The detailed analysis includes techniques to estimate the fair value of loan collateral and the existence of potential alternative sources of repayment. The allowance consists of specific, general, and unallocated components. The Company considers installment loans to be pools of smaller balance, homogenous loans that are collectively evaluated for impairment, unless such loans are subject to a TDR agreement. For such loans that are also classified as impaired, a specific component within the allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan are lower than the carrying value of that loan. The general component covers non-impaired loans and is based upon historical loss experience adjusted for qualitative factors. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio. The appropriateness of the allowance for loan losses is estimated based upon those factors and trends identified by management at the time consolidated financial statements are prepared. When available information confirms that specific loans or portions thereof are uncollectible, identified amounts are charged against the allowance for loan losses. The existence of some or all of the following criteria will generally confirm that a loss has been incurred: the loan is significantly delinquent and the borrower has not demonstrated the ability or intent to bring the loan current; the Company has no recourse to the borrower, or if it does, the borrower has insufficient assets to pay the debt; the estimated fair value of the loan collateral is significantly below the current loan balance, and there is little or no near-term prospect for improvement. The ultimate recovery of all loans is susceptible to future market factors beyond the Company’s control. These factors may result in losses or recoveries differing significantly from those provided in the consolidated financial statements. In addition, regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses, and may require the Company to make additions to the allowance based on their judgment about information available to them at the time of their examinations. Transfers of financial assets – Transfers of an entire financial asset, or a participating interest in an entire financial asset, are accounted for as sales when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when: (1) a group of financial assets or a participating interest in an entire financial asset has been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity. Mortgage servicing rights (‘‘MSR’’) – Mortgage servicing rights represent the value associated with servicing residential mortgage loans, when the mortgage loans have been sold into the secondary market and the related servicing has been retained by the Company. The Company may also purchase mortgage servicing rights. 67 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements The value is determined though a discounted cash flow analysis, which uses interest rates, prepayment speeds and delinquency rate assumptions as inputs. All of these assumptions require a significant degree of management judgment. The Company measures its mortgage servicing assets at fair value and reports changes in fair value through earnings under the caption mortgage banking revenue in the period in which the change occurs. Premises and equipment – Premises, leasehold improvements and furniture and equipment are carried at cost, less accumulated depreciation and amortization. Furniture and equipment are depreciated using the straight-line method over the estimated useful lives of the assets, which range from 1 to 10 years. The cost of leasehold improvements is amortized using the straight-line method over the terms of the related leases. The cost of premises is amortized using the straight-line method over the estimated useful life of the building, up to 39 years. Management reviews premises, leasehold improvements and furniture and equipment for impairment on an annual basis. Bank-owned life insurance, net – The carrying amount of bank owned life insurance approximates its fair value, and is estimated using the cash surrender value, net of any surrender charges. Federal Home Loan Bank stock – The Company is a member of the Federal Home Loan Bank of Des Moines (‘‘FHLB’’). FHLB stock represents the Company’s investment in the FHLB and is carried at par value, which reasonably approximates its fair value. As a member of the FHLB, the Company is required to maintain a minimum level of investment in FHLB stock based on specific percentages of its outstanding mortgages, total assets, or FHLB advances. At December 31, 2018 and 2017, the Company’s minimum required investment in FHLB stock was $4.1 million and $3.1 million, respectively. Typically the Company may request redemption at par value of any stock in excess of the minimum required investment. Stock redemptions are at the discretion of the FHLB. Other real estate owned and repossessed assets – OREO and repossessed assets represent real estate and other assets which the Company has taken control of in partial or full satisfaction of loans. At the time of foreclosure, OREO and repossessed assets are recorded at fair value less estimated costs to sell, which becomes the new basis. Any write-downs based on the asset’s fair value at the date of acquisition are charged to the allowance for loan and lease losses. After foreclosure, management periodically performs valuations such that the property is carried at the lower of its new cost basis or fair value, net of estimated costs to sell. Revenue and expenses from operations and subsequent adjustments to the carrying amount of the property are included in other noninterest expense in the consolidated statements of income. In some instances, the Company may make loans to facilitate the sales of OREO. Management reviews all sales for which it is the lending institution. Any gains related to sales of other real estate owned may be deferred until the buyer has a sufficient investment in the property. Income Taxes – Income taxes are accounted for using the asset and liability method. Under this method a deferred tax asset or liability is determined based on the enacted tax rates which will be in effect when the differences between the financial statement carrying amounts and tax basis of existing assets and liabilities are expected to be reported in the Company’s income tax returns. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. Valuation allowances are established to reduce the net carrying amount of deferred tax assets if it is determined to be more likely than not, that all or some portion of the potential deferred tax asset will not be realized. Segment reporting – The Company operates in one segment and makes management decisions based on consolidated results. The Company’s operations are solely in the financial services industry and include providing to its clients traditional banking and other financial services. Off-balance-sheet credit-related financial instruments – In the normal course of operations, the Company engages in a variety of financial transactions that are not recorded in our financial statements. These transactions involve varying degrees of off-balance sheet credit, interest rate and liquidity risks. These transactions are used primarily to manage customers’ requests for funding and take the form of loan commitments, letters of credit and lines of credit. Such financial instruments are recorded when they are funded. 68 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Advertising costs – The Company expenses advertising costs as they are incurred. Advertising costs, including other marketing expenses were $244,000 and $204,000 for the years ended December 31, 2018 and 2017, respectively. Comprehensive income – Accounting principles generally require that recognized revenue, expenses, gains, and losses be included in net income. Certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale investments, are reported as a separate component of the equity section of the consolidated balance sheets, net of tax. Such items, along with net income, are components of comprehensive income. Intangible assets – At December 31, 2018 and 2017, the Company had $209,000 and $362,000, respectively, of identifiable intangible assets included in other assets as a result of the acquisition of deposits from other institutions. These assets are amortized using the straight-line method over a period of 8-10 years and have a remaining weighted average life of 5.6 years. Management reviews intangible assets for impairment on an annual basis. No impairment losses have been recognized in the periods presented. Employee stock ownership plan (ESOP) – The Company sponsors a leveraged ESOP. As shares are committed to be released, compensation expense is recorded equal to the market price of the shares, and the shares become outstanding for purposes of earnings per share calculations. Cash dividends on allocated shares (those credited to ESOP participants’ accounts) are recorded as a reduction of stockholders’ equity and distributed directly to participants’ accounts. Cash dividends on unallocated shares (those held by the ESOP not yet credited to participants’ accounts) are used to pay administrative expenses and debt service requirements of the ESOP. See Note 13 – Employee Benefits for further information. At December 31, 2018, there were 34,020 unallocated shares in the plan. Shares released on December 31, 2018 totaled 11,340 and will be credited to plan participants’ accounts in 2019. Unearned ESOP shares are shown as a reduction of stockholders’ equity. When the shares are released, unearned common shares held by the ESOP are reduced by the cost of the ESOP shares released and the differential between the fair value and the cost is charged to additional paid in capital. The loan receivable from the ESOP to the Company is not reported as an asset nor is the debt of the ESOP reported as a liability on the Company’s consolidated statements of condition. Earnings Per Common Share – Earnings per share (‘‘EPS’’) is computed using the two-class method. Basic EPS is computed by dividing net income allocated to common shares by the weighted average number of common shares outstanding for the period, excluding any participating securities. Participating securities include unvested restricted shares. Unvested restricted shares are considered participating securities because holders of these securities receive non-forfeitable dividends at the same rate as the holders of the Company’s common stock. Diluted EPS is computed by dividing net income allocated to common shares adjusted for reallocation of undistributed earnings of unvested restricted shares by the weighted average number of common shares determined for the basic EPS plus the dilutive effect of common stock equivalents using the treasury stock method based on the average market price for the period. Some stock options are anti-dilutive and therefore are not included in the calculation of diluted EPS. Fair value – Fair value is the price that would be received when an asset is sold or a liability is transferred in an orderly transaction between market participants at the measurement date. Fair values of the Company’s financial instruments are based on the fair value hierarchy which requires an entity to maximize the use of observable inputs, typically market data obtained from third parties, and minimize the use of unobservable inputs, which reflects its estimates for market assumptions, when measuring fair value. Three levels of valuation inputs are ranked in accordance with the prescribed fair value hierarchy as follows: Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2: Quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active. Level 3: Assets or liabilities whose significant value drivers are unobservable. 69 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements In determining the appropriate levels, the Company performs a detailed analysis of the assets and liabilities that are subject to fair value measurements. In certain cases, the inputs used to measure fair value of an asset or liability may fall into different levels of the fair value hierarchy. The level within which the fair value measurement is categorized is based on the lowest level unobservable input that is significant to the fair value measurement in its entirety. Therefore, an item may be classified in Level 3 even though there may be some significant inputs that are readily observable. Share-Based Compensation – The Company measures the cost of employee services received in exchange for an award of equity instruments based on the grant date fair value of the award. These costs are recognized on a straight-line basis over the vesting period during which an employee is required to provide services in exchange for the award, also known as the requisite service period. The Company uses the Black-Scholes option pricing model to estimate the fair value of stock options granted. When determining the estimated fair value of stock options granted, the Company utilizes various assumptions regarding the expected volatility of the stock price, estimated forfeitures using historical data on employee terminations, the risk-free interest rate for periods within the contractual life of the stock option, and the expected dividend yield that the Company expects over the expected life of the options granted. Reductions in compensation expense associated with forfeited options are estimated at the date of grant, and this estimated forfeiture rate is adjusted monthly based on actual forfeiture experience. The Company measures the fair value of the restricted stock using the closing market price of the Company’s common stock on the date of grant. The Company expenses the grant date fair value of the Company’s stock options and restricted stock with a corresponding increase in equity. Reclassifications – Certain amounts reported in prior years’ consolidated financial statements have been reclassified to conform to the current presentation. The results of the reclassifications are not considered material and have no effect on previously reported net income, earnings per share or stockholders’ equity. Note 2 – Accounting Pronouncements Recently Issued or Adopted In August 2018, the Financial Accounting Standards Board (‘‘FASB’’) issued Accounting Standards Update (‘‘ASU’’) No. 2018-13, ‘‘Fair Value Measurement: Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement’’ (‘‘ASU 2018-13’’). This ASU modifies the disclosure requirements on fair value measurements. The following disclosure requirements were removed from FASB Accounting Standards Codification (‘‘ASC’’) Topic 820 - Fair Value Measurement: (1) the amount of and reasons for transfers between Level 1 and Level 2 of the fair value hierarchy; (2) the policy for timing of transfers between levels; and (3) the valuation processes for Level 3 fair value measurements. This ASU clarifies that the measurement uncertainty disclosure is to communicate information about the uncertainty in measurement as of the reporting date. The ASU adds the following disclosure requirements for Level 3 measurements: (1) changes in unrealized gains and losses for the period included in other comprehensive income for the recurring Level 3 fair value measurements held at the end of the reporting period; and (2) the range and weighted average of significant unobservable inputs used to develop Level 3 fair value measurements. Amendments in this ASU are effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is permitted for any removed or modified disclosures. The adoption of ASU 2018-13 is not expected to have a material impact on the Company’s consolidated financial statements. In June 2018, the FASB issued ASU No. 2018-07, Compensation - Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting. This ASU amends the accounting for share-based payments awards to nonemployees to align with the accounting for employee awards. Under the new guidance, the existing employee guidance will apply to nonemployee share-based transactions (as long as the transaction is not effectively a form of financing), with the exception of specific guidance related to the attribution of compensation cost. The cost of nonemployee awards will continue to be recorded as if the grantor had paid cash for the goods or services. In addition, the contractual term will be able to be used in lieu of an expected term in the option-pricing model for nonemployee awards. Amendments in this ASU are effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2018 and early adoption is permitted. The adoption of ASU No. 2018-07 on January 1, 2019 is not expected to have a material impact on the Company’s consolidated financial statements. 70 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements In March 2018, FASB issued ASU No. 2018-5, Income Taxes (Topic 740). This ASU was issued to provide guidance on the income tax accounting implications of the Tax Cuts and Jobs Act of 2017 (‘‘Tax Act’’) and allows for entities to report provisional amounts for specific income tax effects of the Tax Act for which the accounting under Topic 740 was not yet complete, but a reasonable estimate could be determined. A measurement period of one-year is allowed to complete the accounting effects under Topic 740 and revise any previous estimates reported. Any provisional amounts or subsequent adjustments included in an entity’s financial statements during the measurement period should be included in income from continuing operations as an adjustment to tax expense in the reporting period the amounts are determined. The Company adopted this ASU with the provisional adjustments as reported in the consolidated financial statements on Form 10-K as of December 31, 2017. For the year ended December 31, 2018, the Company did not incur any adjustments to the provisional recognition. In February 2018, FASB issued ASU No. 2018-02, Income Statement - Reporting Comprehensive Income (Topic 220). This ASU was issued to allow a reclassification from accumulated other comprehensive income to retained earnings from stranded tax effects resulting from the revaluation of the Company’s net deferred tax asset (‘‘DTA’’) to the new corporate tax rate of 21% as a result of the ‘‘Tax Act’’. The ASU is effective for reporting periods beginning after December 15, 2018 with early adoption permitted. The adoption of ASU No. 2018-02 did not have a material impact on the Company’s consolidated financial statements. In August 2017, the FASB issued ASU No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities. This ASU amends the hedge accounting recognition and presentation requirements in ASC 815 to improve the transparency and understandability of information conveyed to financial statement users about an entity’s risk management activities by better aligning the entity’s financial reporting for hedging relationships with those risk management activities and reduce the complexity of and simplify the application of hedge accounting by preparers. The amendments in this ASU permit hedge accounting for hedging relationships involving nonfinancial risk and interest rate risk by removing certain limitations in cash flow and fair value hedging relationships. In addition, the ASU requires an entity to present the earnings effect of the hedging instrument in the same income statement line item in which the earnings effect of the hedged item is reported. The amendments in this ASU are effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2018 and early adoption is permitted. The adoption of ASU No. 2017-12 on January 1, 2019, is not expected to have a material impact on the Company’s consolidated financial statements. In May 2017, the FASB issued ASU No. 2017-09, Compensation—Stock Compensation (Topic 718): Scope of Modification Accounting. The ASU was issued to provide clarity as to when to apply modification accounting when there is a change in the terms or conditions of a share-based payment award. According to this ASU, an entity should account for the effects of a modification unless the fair value, vesting conditions, and balance sheet classification of the award is the same after the modification as compared to the original award prior to the modification. The standard was effective for reporting periods beginning after December 15, 2017. The Company has not had any modifications on share-based payment awards and therefore the adoption of ASU No. 2017-09 did not have a material impact on the Company’s consolidated financial statements. In March 2017, the FASB issued ASU No. 2017-08, Receivables-Nonrefundable Fees and Other Costs (Subtopic 310-20). ASU 2017-08 is intended to amend the amortization period for certain purchased callable debt securities held at a premium. Under ASU 2017-08, the FASB is shortening the amortization period for the premium to the earliest call date. Under current GAAP, entities generally amortize the premium as an adjustment of yield over the contractual life of the instrument. ASU 2017-08 is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2018. The adoption of ASU No. 2017-08 on January 1, 2019 is not expected to have a material impact on the Company’s consolidated financial statements. In January 2017, the FASB issued ASU No. 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment, or ASU 2017-04, which eliminates Step 2 from the goodwill impairment test. ASU 2017-04 also eliminates the requirements for any reporting unit with a zero or negative carrying amount to perform a qualitative assessment and, if it fails that qualitative test, to perform Step 2 of the goodwill impairment test. An entity still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary. Adoption of ASU 2017-04 is required for annual or interim goodwill 71 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements impairment tests in fiscal years beginning after December 15, 2019 with early adoption permitted for annual or interim goodwill impairment tests performed on testing dates after January 1, 2017. The Company does not expect the adoption of ASU 2017-04 to have a material impact on its consolidated financial statements. In August 2016, FASB issued ASU No. 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments. This ASU addresses the appropriate classification of eight specific cash flow issues on the cash flow statement. Debt prepayment costs should be classified as an outflow for financing activities. Settlement of zero-coupon debt instruments divides the interest portion as an outflow for operating activities and the principal portion as an outflow for financing activities. Contingent consideration payments made after a business combination should be classified as outflows for financing and operating activities. Proceeds from the settlement of bank-owned life insurance policies should be classified as inflows from investing activities. Other specific areas are identified in the ASU as to the appropriate classification of the cash inflows or outflows. The amendments in this ASU were effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company does not currently have items on its cash flow statement that were impacted by adoption of this ASU and therefore adoption of ASU 2016-15 did not have a material impact on the Company’s consolidated financial statements. In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments- Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. This ASU replaces the existing incurred loss impairment methodology that recognizes credit losses when a probable loss has been incurred with new methodology where loss estimates are based upon lifetime expected credit losses. The amendments in this ASU require a financial asset that is measured at amortized cost to be presented at the net amount expected to be collected. The income statement would then reflect the measurement of credit losses for newly recognized financial assets as well as changes to the expected credit losses that have taken place during the reporting period. The measurement of expected credit losses will be based on historical information, current conditions, and reasonable and supportable forecasts that impact the collectability of the reported amount. Available-for-sale securities will bifurcate the fair value mark and establish an allowance for credit losses through the income statement for the credit portion of that mark. The interest portion will continue to be recognized through accumulated other comprehensive income or loss. The change in allowance recognized as a result of adoption will occur through a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the ASU is adopted. The amendments in this ASU are effective for fiscal years beginning after December 15, 2019 with early adoption permitted after December 15, 2018. The Company is evaluating its current expected loss methodology on the loan and investment portfolios to identify the necessary modifications in accordance with this standard and expects a change in the processes and procedures to calculate the allowance for loan losses, including changes in assumptions and estimates to consider expected credit losses over the life of the loan versus the current accounting practice that utilizes the incurred loss model. The Company is in the process of compiling historical data that will be used to calculate expected credit losses on the loan portfolio to ensure that it is fully compliant with the ASU at the adoption date and is evaluating the potential impact adoption of this ASU will have on its consolidated financial statements. While the Company has not quantified the impact of this ASU, it does expect changing from the current incurred loss model to an expected loss model will result in an earlier recognition of losses. The Company also expects that once adopted the allowance for loan losses will increase, however, until its evaluation is complete the magnitude of the increase will be unknown. In February 2016, FASB issued ASU No. 2016-02, Leases (Topic 842). ASU No. 2016-02 requires lessees to recognize, on the balance sheet, the assets and liabilities arising from operating leases. A lessee should recognize a liability to make lease payments and a right-of-use asset representing its right to use the underlying asset for the lease term. A lessee should include payments to be made in an optional period only if the lessee is reasonably certain to exercise an option to extend the lease or not to exercise an option to terminate the lease. For a finance lease, interest payments should be recognized separately from amortization of the right-of-use asset in the statement of comprehensive income. For operating leases, the lease cost should be allocated over the lease term on a generally straight-line basis. In July 2018, the FASB issued ASU No. 2018-11, Leases (Topic 842), Targeted Improvements. This ASU amended the new leases standard to give entities another option for transition and to provide lessors with a practical expedient. The transition option allows entities to not apply the new leases standard in the comparative periods they present in their financial statements in the year of adoption. The practical expedient provides lessors with an option to not separate non-lease components from the associated 72 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements lease components when certain criteria are met and requires them to account for the combined component in accordance with the new revenue standard if the associated non-lease components are the predominant components. The amendments have the same effective date as ASU 2016-02. The amendments in ASU 2016-02 are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early application of the amendments in the ASU is permitted. The Company is currently evaluating the impact of ASU 2016-02. Upon adoption of this guidance on January 1, 2019, we expect the right-of-use assets and lease liabilities recorded will be less than 5% of our total assets. The Company does not expect the new lease standard to have a material impact on its consolidated financial statements. In January 2016, FASB issued ASU No. 2016-01, Financial Instruments - Overall, Recognition and Measurement of Financial Assets and Financial Liabilities. ASU 2016-01 requires equity investments (except those accounted for under the equity method of accounting) to be measured at fair value with changes in fair value recognized in net income. In addition, the amendments in this ASU require an entity to disclose the fair value of financial instruments using the exit price notion. Exit price is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The methods of determining the fair value of assets and liabilities are consistent with our methodologies disclosed in Note 11 - Fair Value Measurements of this Form 10-K, except for the valuation of loans held-for-investment and time deposits which were impacted by the adoption of ASU 2016-01. Prior to adopting the amendments included in the standard, the Company was allowed to measure fair value under an entry price notion. The entry price notion previously applied by the Company used a discounted cash flows technique to calculate the present value of expected future cash flows for a financial instrument. The exit price notion uses the same approach, but also incorporates other factors, such as enhanced credit risk, illiquidity risk and market factors that sometimes exist in exit prices in dislocated markets. As of December 31, 2018, the technique used by the Company to estimate the exit price of the loan portfolio consists of similar procedures to those used as of December 31, 2017, but with added emphasis on both illiquidity risk and credit risk not captured by the previously applied entry price notion. This credit risk assumption is intended to approximate the fair value that a market participant would realize in a hypothetical orderly transaction. The amendments in this ASU were effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Refer to Note 11 of this Form 10-K. Prior period information has not been updated to conform with the new guidance. The adoption of ASU 2016-01 did not have a material impact on the Company’s consolidated financial statements. In May 2014, the ‘‘FASB’’ issued ‘‘ASU’’ No. 2014-09, Revenue from Contracts with Customers (Topic 606). In August 2015, FASB issued ASU No. 2015-14, Revenue from Contracts with Customers (Topic 606) which postponed the effective date of 2014-09. Subsequently, in March 2016, the FASB issued ASU 2016-08, Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations. This amendment clarifies that an entity should determine if it is the principal or the agent for each specified good or service promised in a contract with a customer. In April 2016, the FASB issued ASU No. 2016-10, Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing. The core principle of Topic 606 is that an entity must recognize revenue when it has satisfied a performance obligation of transferring promised goods or services to a customer. These standards were effective for interim and annual periods beginning after December 15, 2017. The Company has analyzed its revenue sources of noninterest income to determine when the satisfaction of the performance obligation occurs and the appropriate recognition of revenue. For further information, see Note 19 - Revenue from Contracts with Customers of this Form 10-K. The adoption of these ASUs did not have a material impact on the Company’s consolidated financial statements, other than the additional disclosures included in Note 19 of this Form 10-K. Note 3 – Restricted Cash Federal Reserve Board regulations require that the Company maintain certain minimum reserve balances either as cash on hand or on deposit with the Federal Reserve Bank, based on a percentage of deposits. The reserve balances were $13.8 million and $12.2 million at December 31, 2018 and 2017, respectively. 73 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Note 4 – Investments The amortized cost and fair value of AFS securities and the corresponding amounts of gross unrealized gains and losses at December 31, 2018 and 2017 were as follows (in thousands): December 31, 2018 Municipal bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Agency mortgage-backed securities . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . December 31, 2017 Municipal bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Agency mortgage-backed securities . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value $3,218 1,594 $4,812 $3,240 2,030 $5,270 $122 46 $168 $155 36 $191 $(23) — $(23) $(26) — $(26) $3,317 1,640 $4,957 $3,369 2,066 $5,435 The amortized cost and fair value of AFS securities at December 31, 2018, by contractual maturity, are shown below (in thousands). Expected maturities of AFS securities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Investments not due at a single maturity date, primarily mortgage-backed securities, are shown separately. Due in one to five years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Due after five to ten years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Due after ten years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mortgage-backed securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . December 31, 2018 Amortized Cost $1,566 460 1,192 1,594 $4,812 Fair Value $1,550 485 1,282 1,640 $4,957 Weighted- Average Yield 1.93% 4.75 5.43 4.14 3.82% There were no pledged securities at December 31, 2018 and 2017. There were no sales of AFS securities during the years ended December 31, 2018 and 2017. The following tables summarize the aggregate fair value and gross unrealized loss by length of time of those investments that have been in a continuous unrealized loss position at December 31, 2018 and 2017 (in thousands): Municipal bonds . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $— $— $— $— Less Than 12 Months Unrealized Fair Loss Value December 31, 2018 12 Months or Longer Unrealized Loss Fair Value $1,283 $1,283 $(23) $(23) Total Fair Value $1,283 $1,283 Unrealized Loss $(23) $(23) Less Than 12 Months Unrealized Fair Loss Value December 31, 2017 12 Months or Longer Unrealized Loss Fair Value Total Fair Value Unrealized Loss Municipal bonds . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $— $— $— $— $1,302 $1,302 $(26) $(26) $1,302 $1,302 $(26) $(26) 74 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements There were no credit losses recognized in earnings during the years ended December 31, 2018 and 2017 relating to the Company’s securities. At December 31, 2018, the securities portfolio consisted of six agency mortgage-backed securities and eight municipal securities with a fair value of $5.0 million. At December 31, 2017, the securities portfolio consisted of seven agency mortgage-backed securities and eight municipal bonds with a fair value of $5.4 million. At both the December 31, 2018 and 2017, there were no securities in an unrealized loss position for less than 12 months, and there were three municipal securities in an unrealized loss position for more than 12 months. For both the 2018 and 2017 periods, the unrealized losses were caused by changes in market interest rates or the widening of market spreads subsequent to the initial purchase of these securities, and not related to the underlying credit of the issuers or the underlying collateral. It is expected that these securities will not be settled at a price less than the amortized cost of each investment. The unrealized losses on these investments are not considered other-than-temporary impairment (‘‘OTTI’’) during the years ended December 31, 2018 and 2017, because the decline in fair value is not attributable to credit quality and because we do not intend, and it is not likely that we will be required, to sell these securities before recovery of their amortized cost basis. Note 5 – Loans The composition of the loan portfolio, excluding loans held-for-sale, at December 31, 2018 and 2017 is as follows (in thousands): Real estate loans: One- to four-family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Home equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial and multifamily. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Construction and land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total real estate loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer loans: Manufactured homes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Floating homes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total consumer loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total loans, gross . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Allowance for loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . At December 31, 2018 2017 $169,830 27,655 252,644 65,259 515,388 20,145 40,806 6,628 67,579 38,804 621,771 (2,228) 619,543 (5,774) $157,417 28,379 211,269 61,482 458,547 17,111 29,120 4,902 51,133 40,829 550,509 (1,914) 548,595 (5,241) Total loans, net. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $613,769 $543,354 75 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements The following table presents the balance in the allowance for loan losses and the unpaid principal balance in loans, net of partial charge-offs by portfolio segment and based on impairment method as of December 31, 2018 (in thousands): Allowance: Individually evaluated for impairment $228 25 Allowance: Collectively evaluated for impairment $1,086 177 Ending balance $1,314 202 Loans held for investment: Individually evaluated for impairment $2,760 440 Loans held for investment: Collectively evaluated for impairment $167,070 27,215 — 8 299 — 64 112 — $736 1,638 423 128 265 48 244 1,029 $5,038 1,638 431 427 265 112 356 1,029 $5,774 702 163 424 — 157 1,192 — $5,838 251,942 65,096 19,721 40,806 6,471 37,612 — $615,933 Ending balance $169,830 27,655 252,644 65,259 20,145 40,806 6,628 38,804 — $621,771 One- to four-family. . . . . . Home equity . . . . . . . . . . . Commercial and multifamily . . . . . . . . . . Construction and land. . . . Manufactured homes . . . . Floating homes . . . . . . . . . Other consumer. . . . . . . . . Commercial business . . . . Unallocated . . . . . . . . . . . . Total. . . . . . . . . . . . . . . . The following table presents the balance in the allowance for loan losses and the unpaid principal balance in loans, net of partial charge-offs by portfolio segment and based on impairment method as of December 31, 2017 (in thousands): Allowance: Individually evaluated for impairment $ 555 120 Allowance: Collectively evaluated for impairment $ 881 173 Ending balance $1,436 293 Loans held for investment: Individually evaluated for impairment $ 6,256 1,028 Loans held for investment: Collectively evaluated for impairment $151,161 27,351 — 13 258 — 43 135 — $1,124 1,250 365 97 169 37 237 908 $4,117 1,250 378 355 169 80 372 908 $5,241 1,699 141 385 — 194 1,000 — $10,703 209,570 61,341 16,726 29,120 4,708 39,829 — $539,806 Ending balance $157,417 28,379 211,269 61,482 17,111 29,120 4,902 40,829 — $550,509 One- to four-family. . . . . . Home equity . . . . . . . . . . . Commercial and multifamily . . . . . . . . . . Construction and land. . . . Manufactured homes . . . . Floating homes . . . . . . . . . Other consumer. . . . . . . . . Commercial business . . . . Unallocated . . . . . . . . . . . . Total. . . . . . . . . . . . . . . . The following table summarizes the activity in the allowance for loan losses for the year ended December 31, 2018 (in thousands): One- to four-family . . . . . . . . . . . . . . . . . . . . . . . . . . . Home equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial and multifamily. . . . . . . . . . . . . . . . . . . . Construction and land . . . . . . . . . . . . . . . . . . . . . . . . . Manufactured homes . . . . . . . . . . . . . . . . . . . . . . . . . . Floating homes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business . . . . . . . . . . . . . . . . . . . . . . . . . . Unallocated. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Charge-offs $ — (7) — — (12) — (31) — — $(50) Recoveries $ 1 44 — — — — 12 1 — $58 Provision $(123) (128) 388 53 84 96 51 (17) 121 $ 525 Ending Allowance $1,314 202 1,638 431 427 265 112 356 1,029 $5,774 Beginning Allowance $1,436 293 1,250 378 355 169 80 372 908 $5,241 76 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements The following table summarizes the activity in the allowance for loan losses for the year ended December 31, 2017 (in thousands): One- to four-family . . . . . . . . . . . . . . . . . . . . . . . . . . . Home equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial and multifamily. . . . . . . . . . . . . . . . . . . . Construction and land . . . . . . . . . . . . . . . . . . . . . . . . . Manufactured homes . . . . . . . . . . . . . . . . . . . . . . . . . . Floating homes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business . . . . . . . . . . . . . . . . . . . . . . . . . . Unallocated. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Beginning Allowance $1,542 378 1,144 459 168 132 112 175 712 $4,822 Charge-offs Recoveries Provision $ — (89) (24) — (12) — (18) — — $(143) $— 33 1 — 8 — 20 — — $62 $(106) (29) 129 (81) 191 37 (34) 197 196 $ 500 Ending Allowance $1,436 293 1,250 378 355 169 80 372 908 $5,241 Credit Quality Indicators. Federal regulations provide for the classification of lower quality loans as substandard, doubtful or loss. A loan is considered substandard if it is inadequately protected by the current net worth and pay capacity of the borrower or of any collateral pledged. Substandard loans include those characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected. Loans classified as doubtful have all the weaknesses of currently existing facts, conditions and values. Loans classified as loss are those considered uncollectible and of such little value that their continuance as assets without establishment of a specific loss reserve is not warranted. When the Company classifies problem loans as either substandard or doubtful, it may establish a specific allowance in an amount it deems prudent to address the risk specifically (if the loan is impaired) or it may allow the loss to be addressed in the general allowance (if the loan is not impaired). General allowances represent loss reserves which have been established to recognize the inherent risk associated with lending activities, but which, unlike specific allowances, have not been specifically allocated to particular problem assets. When the Company classifies problem loans as a loss, it charges off such loans in the period in which they are deemed uncollectible. Loans that do not currently expose the Company to sufficient risk to warrant classification as substandard or doubtful but possess identified weaknesses are classified as either watch or special mention loans. The Company’s determination as the classification of its loans and the amount of its valuation allowances is subject to review by the FDIC, which can order the establishment of additional loss allowances. Pass rated loans are loans that are not otherwise classified or criticized. The following table represents the internally assigned grades as of December 31, 2018, by type of loan (in thousands): One- to four- family Home equity Commercial and multifamily Construction and land Manufactured homes Floating homes Other consumer Commercial business Total Grade: Pass . . . . . . . . . . . $163,655 $27,150 — Watch . . . . . . . . . . — Special Mention . . 505 Substandard. . . . . . — Doubtful . . . . . . . . — Loss . . . . . . . . . . . — — 6,175 — — $246,907 1,139 2,497 2,101 — — Total . . . . . . . . . . . $169,830 $27,655 $252,644 $55,916 5,968 3,252 123 — — $65,259 $19,860 — — 285 — — $40,806 — — — — — $6,576 — — 52 — — $35,876 689 367 1,872 — — $596,746 7,796 6,116 11,113 — — $20,145 $40,806 $6,628 $38,804 $621,771 77 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements The following table represents the internally assigned grades as of December 31, 2017, by type of loan (in thousands): One- to four- family Home equity Commercial and multifamily Construction and land Manufactured homes Floating homes Other consumer Commercial business Total Grade: Pass . . . . . . . . . . . $153,793 $27,493 — Watch . . . . . . . . . . — Special Mention . . 886 Substandard. . . . . . — Doubtful . . . . . . . . — Loss . . . . . . . . . . . 244 137 3,243 — — $199,887 9,683 357 1,342 — — Total . . . . . . . . . . . $157,417 $28,379 $211,269 $61,390 — — 92 — — $61,482 $16,877 — — 234 — — $29,120 — — — — — $4,708 — — 194 — — $39,089 827 784 129 — — $532,357 10,754 1,278 6,120 — — $17,111 $29,120 $4,902 $40,829 $550,509 Nonaccrual and Past Due Loans. Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are automatically placed on nonaccrual once the loan is ninety days past due or if, in management’s opinion, the borrower may be unable to meet payment of obligations as they become due, as well as when required by regulatory provisions. The following table presents the recorded investment in nonaccrual loans as of December 31, 2018 and 2017, by type of loan (in thousands): One- to four-family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Home equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial and multifamily . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Construction and land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Manufactured homes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2018 $1,075 360 — 534 123 214 235 $2,541 2017 $ 791 722 8 201 92 206 129 $2,149 The following table represents the aging of the recorded investment in past due loans as of December 31, 2018, by type of loan (in thousands): 30-59 Days Past Due 60-89 Days Past Due Greater than 90 Days Past Due Recorded Investment > 90 Days and Accruing One- to four-family . . . . . . . . . . Home equity . . . . . . . . . . . . . . . Commercial and multifamily . . Construction and land . . . . . . . . Manufactured homes. . . . . . . . . Floating homes . . . . . . . . . . . . . Other consumer . . . . . . . . . . . . . Commercial business . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . $1,362 298 139 650 78 — 11 228 $2,766 $167 149 — — 129 — 5 177 $627 $ 514 284 353 50 199 — — 122 $1,522 $— — — — — — — — $— Total Past Due $2,043 731 492 700 406 — 16 527 Current $167,787 26,924 252,152 64,559 19,739 40,806 6,612 38,277 Total Loans $169,830 27,655 252,644 65,259 20,145 40,806 6,628 38,804 $4,915 $616,856 $621,771 78 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements The following table represents the aging of the recorded investment in past due loans as of December 31, 2017, by type of loan (in thousands): 30-59 Days Past Due 60-89 Days Past Due Greater Than 90 Days Past Due Recorded Investment > 90 Days and Accruing One- to four-family . . . . . . . . . . Home equity . . . . . . . . . . . . . . . Commercial and multifamily . . Construction and land . . . . . . . . Manufactured homes. . . . . . . . . Floating homes . . . . . . . . . . . . . Other consumer . . . . . . . . . . . . . Commercial business . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . $2,092 521 313 51 185 — 15 400 $3,577 $1,819 5 — — 50 — — — $1,874 $ 727 633 — 92 197 — — — $1,649 $— — — — — — — — $— Total Past Due $4,638 1,159 313 143 432 — 15 400 Current $152,779 27,220 210,956 61,339 16,679 29,120 4,887 40,429 Total Loans $157,417 28,379 211,269 61,482 17,111 29,120 4,902 40,829 $7,100 $543,409 $550,509 Nonperforming Loans. Loans are considered nonperforming when they are placed on nonaccrual and/or when they are considered to be nonperforming TDRs and/or when they are 90 days or greater past due. Nonperforming TDRs include TDRs that do not have sufficient payment history (typically greater than 6 months) to be considered performing or TDRs that have become 31 or more days past due. The following table represents the credit risk profile based on payment activity as of December 31, 2018, by type of loan (in thousands): One- to four- family Home equity Commercial and multifamily Construction and land Manufactured homes Floating homes Other consumer Commercial business Total Performing . . . . . $168,710 $27,296 $252,110 534 1,120 Nonperforming . . 359 $65,136 123 $19,931 214 $40,806 $6,628 — — $38,487 $619,104 2,667 317 Total . . . . . . . . $169,830 $27,655 $252,644 $65,259 $20,145 $40,806 $6,628 $38,804 $621,771 The following table represents the credit risk profile based on payment activity as of December 31, 2017, by type of loan (in thousands): One- to four- family Home equity Commercial and multifamily Performing . . . . . $156,580 $27,657 $211,068 201 Nonperforming . . 722 837 Construction and land Manufactured homes Floating homes Other consumer Commercial business Total $61,390 92 $16,905 206 $29,120 $4,894 8 — $40,612 $548,226 2,283 217 Total . . . . . . . . $157,417 $28,379 $211,269 $61,482 $17,111 $29,120 $4,902 $40,829 $550,509 Impaired Loans. A loan is considered impaired when the Company has determined that it may be unable to collect payments of principal or interest when due under the terms of the loan. In the process of identifying loans as impaired, the Company takes into consideration factors which include payment history and status, collateral value, financial condition of the borrower, and the probability of collecting scheduled payments in the future. Minor payment delays and insignificant payment shortfalls typically do not result in a loan being classified as impaired. The significance of payment delays and shortfalls is considered on a case by case basis, after taking into consideration the totality of circumstances surrounding the loans and the borrowers, including payment history and amounts of any payment shortfall, length and reason for delay, and likelihood of return to stable performance. Impairment is measured on a loan by loan basis for all loans in the portfolio. All TDRs are also classified as impaired loans and are included in the loans individually evaluated for impairment in the calculation of the allowance for loan losses. 79 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Impaired loans at December 31, 2018 and 2017, by type of loan were as follows (in thousands): One- to four-family . . . . . . . . . . . . . . . . . . . . . . . . . . . Home equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial and multifamily. . . . . . . . . . . . . . . . . . . . Construction and land . . . . . . . . . . . . . . . . . . . . . . . . . Manufactured homes . . . . . . . . . . . . . . . . . . . . . . . . . . Other consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . One- to four-family . . . . . . . . . . . . . . . . . . . . . . . . . . . Home equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial and multifamily. . . . . . . . . . . . . . . . . . . . Construction and land . . . . . . . . . . . . . . . . . . . . . . . . . Manufactured homes . . . . . . . . . . . . . . . . . . . . . . . . . . Other consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business . . . . . . . . . . . . . . . . . . . . . . . . . . Unpaid Principal Balance $2,894 520 702 163 430 156 1,192 $6,057 Unpaid Principal Balance $ 6,562 1,149 1,722 141 409 194 1,017 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $11,194 December 31, 2018 Recorded Investment Without Allowance With Allowance Total Recorded Investment Related Allowance $1,085 359 702 123 — — 659 $2,928 $1,675 81 — 40 424 157 533 $2,910 $2,760 440 702 163 424 157 1,192 $5,838 $228 25 — 8 299 64 112 $736 December 31, 2017 Recorded Investment Without Allowance With Allowance Total Recorded Investment Related Allowance $3,197 677 1,699 100 23 125 784 $6,605 $3,059 351 — 41 362 69 216 $4,098 $ 6,256 1,028 1,699 141 385 194 1,000 $10,703 $ 555 120 — 13 258 43 135 $1,124 Income on impaired loans for the year ended December 31, 2018 and 2017, by type of loan were as follows (in thousands): Year Ended December 31, 2018 Year Ended December 31, 2017 Average Recorded Investment Interest Income Recognized Average Recorded Investment Interest Income Recognized One- to four-family . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Home equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial and multifamily . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Construction and land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Manufactured homes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,704 740 2,564 726 414 169 1,854 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $11,171 $214 29 140 95 35 9 140 $662 $5,514 931 1,643 112 349 129 809 $9,487 $320 38 96 4 29 10 62 $559 Forgone interest on nonaccrual loans was $172,000 and $33,000 for the year ended December 31, 2018 and 2017, respectively. There were no commitments to lend additional funds to borrowers whose loans were classified as nonaccrual, TDR or impaired at December 31, 2018 and 2017. Troubled debt restructurings. Loans classified as TDRs totaled $2.8 million and $3.7 million at December 31, 2018 and 2017, respectively, and are included in impaired loans. A TDR is a loan to a borrower that is 80 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements experiencing financial difficulty that has been modified from its original terms and conditions in such a way that the Company is granting the borrower a concession of some kind. The Company has granted, in its TDRs, a variety of concessions to borrowers in the form of loan modifications. The modifications granted can generally be described in the following categories: Rate Modification: A modification in which the interest rate is changed. Term Modification: A modification in which the maturity date, timing of payments or frequency of payments is changed. Payment Modifications: A modification in which the dollar amount of the payment is changed. Interest only modifications in which a loan is converted to interest only payments for a period of time are included in this category. Combination Modification: Any other type of modification, including the use of multiple categories above. There were six loans totaling $695,000, that were modified as a TDR during the year ended December 31, 2018. The following TDR loans were paid off during the year ended December 31, 2018: two one- to four-family residential loans totaling $1.4 million and two home equity loans totaling $95,000. In addition to the aforementioned payoffs, there was a charge-off of one manufactured home TDR loan totaling $11,000 during the year ended December 31, 2018. There was one post-modification change of $11,000 charge-offs in manufactured home loans, that was recorded as a result of the TDRs for the year ended December 31, 2018. There were no post-modification changes for the unpaid principal balance in loans, net of partial charge-offs, that were recorded as a result of the TDRs for the year ended December 31, 2017. There were three TDRs totaling $362,000 for which there was a payment default within the first 12 months of modification during the year ended December 31, 2018. There were no TDRs for which there was a payment default within the first 12 months of modification during the year ended December 31, 2017. In the ordinary course of business, the Company makes loans to its directors and officers. Certain loans to directors, officers, and employees are offered at discounted rates as compared to other clients as permitted by federal regulations. Employees, officers, and directors are eligible for mortgage loans with an adjustable rate that resets annually to 1% over the rolling cost of funds. Employees and officers are eligible for consumer loans that are 1% below the market loan rate at the time of origination. Director and officer loans are summarized as follows (in thousands): Balance, beginning of period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Advances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . New / (reclassified) loans, net(1). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Repayments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance, end of period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . December 31, 2018 $4,012 291 (526) (407) $3,370 2017 $3,180 248 1,387 (803) $4,012 (1) Reclassified loans relate to changes in related parties during the year. At December 31, 2018 and 2017, loans totaling $5.8 million and $8.1 million, respectively, represented real estate secured loans that had current loan-to-value ratios above supervisory guidelines. Note 6 – Mortgage Servicing Rights The unpaid principal balances of loans serviced for Federal National Mortgage Association (‘‘Fannie Mae’’) at December 31, 2018 and 2017, totaled $352.2 million and $361.1 million, respectively, and are not included in the Company’s consolidated financial statements. We also service loans for other financial institutions for which a servicing fee is received. The unpaid principal balances of loans serviced for other financial institutions at 81 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements December 31, 2018 and 2017, totaled $2.2 million and $19.9 million, respectively, and are not included in the Company’s financial statements. In addition to the foregoing, there were $24.3 million and $31.5 million of loans from Fannie Mae and other financial institutions not included in the Company’s financial statements at December 31, 2018 and 2017, respectively, for which we outsource the servicing and pay a fee to third party. A summary of the change in the balance of mortgage servicing assets at December 31, 2018 and 2017 is as follows (in thousands): Beginning balance, at fair value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Servicing rights that result from transfers and sale of financial assets. . . . . . . . . . . . . . . . Changes in fair value: Due to changes in model inputs or assumptions(1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ending balance, at fair value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . At December 31, 2018 $3,426 482 2017 $3,561 277 (494) (412) $3,414 $3,426 (1) Represents changes due to collection/realization of expected cash flows and curtailments. The key economic assumptions used in determining the fair value of mortgage servicing rights at the dates indicated are as follows: Prepayment speed (Public Securities Association ‘‘PSA’’ model). . . . . . . . . . . . . . . . . . . . Weighted-average life . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Yield to maturity discount rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123% 7.7 years 12.5% 160% 6.9 years 13.0% The amounts of contractually specified servicing, late and ancillary fees earned and recorded, net of fair value market adjustments to the mortgage servicing rights, are included in mortgage servicing income on the Consolidated Statements of Income which were $562,000 and $566,000, for the years ended December 31, 2018 and 2017, respectively. At December 31, 2018 2017 Note 7 – Premises and Equipment Premises and equipment at December 31, 2018 and 2017 are summarized as follows (in thousands): Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Buildings and improvements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Furniture and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . At December 31, $ 2018 920 6,393 5,203 $ 2017 920 6,302 4,715 Less: Accumulated depreciation and amortization. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (5,472) (4,545) Premises and equipment, net. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,044 $ 7,392 Depreciation and amortization expense was $989,000 and $943,000, for the years ended December 31, 2018 and 2017, respectively. The Company leases office space in several buildings. Generally, operating leases contain renewal options and provisions requiring the Company to pay property taxes and operating expenses over base period amounts. All rental payments are dependent only upon the lapse of time. 82 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Minimum rental payments under non-cancelable operating leases with initial or remaining terms of one year or more are as follows (in thousands): Year Ended December 31, 2019 2020 2021 2022 2023 Thereafter Amount $1,085 1,043 986 960 931 4,820 $9,825 The total rental expense for the years ended December 31, 2018 and 2017 for all facilities leased under operating leases was approximately $1.4 million and $1.1 million, respectively. Note 8 – Other Real Estate Owned and Repossessed Assets The following table presents activity related to OREO and other repossessed assets for the periods shown (in thousands): Beginning balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Additions to OREO and repossessed assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Write-downs/Losses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Year Ended December 31, 2018 $610 55 (16) (74) $575 2017 $1,172 — (468) (94) $ 610 Note 9 – Deposits A summary of deposit accounts with the corresponding weighted average cost of funds at December 31, 2018 and 2017, are presented below (dollars in thousands): As of December 31, 2018 Wtd. Avg Deposit Rate Balance As of December 31, 2017 Wtd. Avg Deposit Rate Balance Noninterest-bearing demand . . . . . . . . . . . . . . . . . . . . . . . . . Interest-bearing demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . Savings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Money market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Certificates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Escrow(1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 93,823 164,919 54,102 46,689 191,825 2,243 $553,601 —% 0.47 0.29 0.24 1.58 — 0.71% $ 69,094 173,413 49,450 54,860 164,554 3,029 $514,400 —% 0.43 0.21 0.21 1.33 — 0.61% (1) Escrow balances shown in noninterest-bearing deposits on the consolidated balance sheets. 83 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Scheduled maturities of time deposits at December 31, 2018, are as follows (in thousands): Year Ending December 31, 2019 2020 2021 2022 Thereafter Amount $110,749 53,052 16,129 8,509 3,386 $191,825 Savings, demand, and money market accounts have no contractual maturity. Certificates of deposit have maturities of five years or less. The aggregate amount of time deposits in denominations of more than $250,000 at December 31, 2018 and 2017, was approximately $52.7 million and $47.1 million, respectively. Deposits in excess of $250,000 are not federally insured. There were no brokered deposits outstanding at December 31, 2018 compared to $512,000 at December 31, 2017. Deposits from related parties held by the Company were $2.8 million and $1.7 million at December 31, 2018 and 2017, respectively. Note 10 – Borrowings The Company utilizes a loan agreement with the FHLB. The terms of the agreement call for a blanket pledge of a portion of the Company’s mortgage and commercial and multifamily portfolio based on the outstanding balance. At December 31, 2018 and 2017, the amount available to borrow under this credit facility was $321.5 million and $217.6 million, respectively. At December 31, 2018, the credit facility was collateralized as follows: one- to four-family mortgage loans with an advance equivalent of $128.4 million, commercial and multifamily mortgage loans with an advance equivalent of $119.8 million and home equity loans with an advance equivalent of $6.3 million. At December 31, 2017, the credit facility was collateralized as follows: one- to four- family mortgage loans with an advance equivalent of $111.5 million, commercial and multifamily mortgage loans with an advance equivalent of $103.0 million and home equity loans with an advance equivalent of $15.2 million. The Company had outstanding borrowings under this arrangement of $84.0 million and $59.0 million at December 31, 2018 and 2017, respectively. The weighted-average interest rate of our borrowings was 2.72% at December 31, 2018 and was 1.63% at December 31, 2017. Additionally, the Company had outstanding letters of credit from the FHLB of Des Moines with a notional amount of $14.5 million both at December 31, 2018 and 2017, respectively, to secure public deposits. The remaining amount available to borrow as of December 31, 2018 and 2017, was $156.0 million and $144.1 million, respectively. Overnight federal funds with contractual principal repayments of $59.0 million, with a weighted-average interest rate of 2.63% and a Repo with contractual principal repayments of $8.8 million, with a weighted-average interest rate of 2.85% at December 31, 2018, are due within one year. Fixed rate advances of $8.8 million, with a weighted-average interest rate of 2.96% are due within a year and $7.5 million, with a weighted-average interest rate of 3.05%, are due in one through three years. The maximum amount outstanding from the FHLB under term advances at month-end during 2018 was $99.5 million and during 2017 was $61.5 million. The average balance outstanding was $69.9 million during 2018 and $29.8 million during 2017. The weighted-average interest rate on the borrowings was 2.18% in 2018 and 1.16% in 2017. As a member of the FHLB system, the Bank is required to maintain a minimum level of investment in the FHLB of Des Moines stock based on specific percentages of its outstanding FHLB advances. At December 31, 2018 and 2017, the Company had an investment of $4.1 million and $3.1 million, respectively, in FHLB of Des Moines stock. 84 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements The Company participates in the Federal Reserve Bank (‘‘FRB’’) Borrower-in-Custody program, which gives the Company access to the discount window. The terms of the program call for a pledge of specific assets. The Company pledges commercial and consumer loans as collateral for this line of credit. The Company had unused borrowing capacity of $47.3 million and $51.2 million and no outstanding borrowings under this program at December 31, 2018 and 2017, respectively. The Company has access to an unsecured Fed Funds line of credit from the Pacific Coast Banker’s Bank. The line has a one-year term maturing on June 30, 2019 and is renewable annually. As of December 31, 2018, the amount available under this line of credit was $2.0 million. There was no balance on this line of credit as of December 31, 2018 and 2017, respectively. The Company has access to a Fed Funds line of credit from Zions Bank under a Fed Funds Sweep and Line Agreement. The agreement allows access to a Fed Funds Line of up to $9.0 million and requires the Company to maintain cash balances with Zions Bank of $250,000. The agreement may be terminated by either party. There was no balance on this line of credit as of December 31, 2018 and 2017, respectively. The Company has access to an unsecured Fed Funds line of credit from The Independent Bank (TIB). As of December 31, 2018, the amount available under this line of credit was $10.0 million. The agreement may be terminated by either party. There was no balance on this line of credit as of December 31, 2018 and 2017, respectively. Note 11 – Fair Value Measurements On January 1, 2018, the Company adopted ASU 2016-01, which requires us to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes. The Company determines the fair values of its financial instruments based on the requirements established in ASC 820, Fair Value Measurements, which provides a framework for measuring fair value in accordance with U.S. GAAP and requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. ASC 820 defines fair values for financial instruments as the exit price, the price that would be received for an asset or paid to transfer a liability, in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date under current market conditions. The Company’s fair values for financial instruments at December 31, 2018 were determined based on these requirements. The following methods and assumptions were used to estimate the fair value of other financial instruments: Cash and cash equivalents - The estimated fair value is equal to the carrying amount. Available-for-Sale Securities - Available-for-sale securities are recorded at fair value based on quoted market prices, if available. If quoted market prices are not available, management utilizes third-party pricing services or broker quotations from dealers in the specific instruments. Level 2 securities include those traded on an active exchange, as well as U.S. government securities. Loans Held-for-Sale - Residential mortgage loans held-for-sale are recorded at the lower of cost or fair value. The fair value of fixed-rate residential loans is based on whole loan forward prices obtained from government sponsored enterprises. At December 31, 2018 and 2017, loans held-for-sale were carried at cost, as no impairment was required. Loans Held for Portfolio - The estimated fair value of loans consists of a credit adjustment to reflect the estimated adjustment to the carrying value of the loans due to credit-related factors and a yield adjustment, to reflect the estimated adjustment to the carrying value of the loans due to a differential in yield between the portfolio loan yields and estimated current market rate yields on loans with similar characteristics. Mortgage Servicing Rights -The fair value of mortgage servicing rights is determined through a discounted cash flow analysis, which uses interest rates, prepayment speeds, discount rates, and delinquency rate assumptions as inputs. FHLB stock - The estimated fair value is equal to the par value of the stock. 85 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Non-maturity deposits - The estimated fair value is equal to the carrying amount. Time deposits - The estimated fair value of time deposits is based on the difference between interest costs paid on the Company’s time deposits and current market rates for time deposits with comparable characteristics. Borrowings - The fair value of borrowings are estimated using the Company’s current incremental borrowing rates for similar types of borrowing arrangements. A description of the valuation methodologies used for impaired loans and OREO is as follows: Impaired Loans - The fair value of collateral dependent loans is based on the current appraised value of the collateral less estimated costs to sell, or internally developed models utilizing a calculation of expected discounted cash flows which contain management’s assumptions. OREO and Repossessed Assets - The fair value of OREO and repossessed assets is based on the current appraised value of the collateral less estimated costs to sell. Off-balance sheet financial instruments - The fair value for the Company’s off-balance sheet loan commitments are estimated based on fees charged to others to enter into similar agreements taking into account the remaining terms of the agreements and credit standing of the Company’s clients. The estimated fair value of these commitments is not significant. The following tables present information about the level in the fair value hierarchy for the Company’s financial instruments as of December 31, 2018 and 2017 (in thousands): FINANCIAL ASSETS: Cash and cash equivalents . . . . . . . . . . . . . . . Available for sale securities . . . . . . . . . . . . . . Loans held-for-sale. . . . . . . . . . . . . . . . . . . . . Loans held for portfolio, net(1) . . . . . . . . . . . Mortgage servicing rights . . . . . . . . . . . . . . . FHLB Stock . . . . . . . . . . . . . . . . . . . . . . . . . . FINANCIAL LIABILITIES: Non-maturity deposits . . . . . . . . . . . . . . . . . . Time deposits(1) . . . . . . . . . . . . . . . . . . . . . . . Borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . FINANCIAL ASSETS: Cash and cash equivalents . . . . . . . . . . . . . . . Available for sale securities . . . . . . . . . . . . . . Loans held-for-sale. . . . . . . . . . . . . . . . . . . . . Loans held for portfolio, net(1) . . . . . . . . . . . Mortgage servicing rights . . . . . . . . . . . . . . . FHLB Stock . . . . . . . . . . . . . . . . . . . . . . . . . . FINANCIAL LIABILITIES: Non-maturity deposits . . . . . . . . . . . . . . . . . . Time deposits(1) . . . . . . . . . . . . . . . . . . . . . . . Borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . December 31, 2018 Fair Value Measurements Using: Carrying Value Estimated Fair Value Level 1 Level 2 Level 3 $ 61,810 4,957 1,172 613,769 3,414 4,134 361,776 191,825 84,000 $ 61,810 4,957 1,172 613,371 3,414 4,134 361,776 191,679 84,000 $61,810 — — — — — $ — $ 4,957 1,172 — — 4,134 — — — 361,776 191,679 84,000 — — — 613,371 3,414 — — — — December 31, 2017 Fair Value Measurements Using: Carrying Value Estimated Fair Value Level 1 Level 2 Level 3 $ 60,680 5,435 1,777 543,354 3,426 3,065 349,846 164,554 59,000 $ 60,680 5,435 1,777 543,400 3,426 3,065 349,846 163,485 59,000 $60,680 — — — — — $ — $ 5,435 1,777 — — 3,065 — — — 349,846 163,485 59,000 — — — 543,400 3,426 — — — — (1) The estimated fair values of loans held for portfolio, net and time deposits for December 31, 2018 reflect exit price assumptions. The December 31, 2017 fair value estimates are not based on exit price assumptions. 86 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements The following tables present the balance of assets measured at fair value on a recurring basis as of December 31, 2018 and 2017 (in thousands): Description Municipal bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Agency mortgage-backed securities . . . . . . . . . . . . . . . . . . . . . . . . Mortgage servicing rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Description Municipal bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Agency mortgage-backed securities . . . . . . . . . . . . . . . . . . . . . . . . Mortgage servicing rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fair Value at December 31, 2018 Level 1 $— — — Level 2 $3,317 1,640 — Fair Value at December 31, 2017 Level 1 $— — — Level 2 $3,369 2,066 — Level 3 $ — — 3,414 Level 3 $ — — 3,426 Total $3,317 1,640 3,414 Total $3,369 2,066 3,426 For the years ended December 31, 2018 and 2017, there were no transfers between Level 1 and Level 2 or between Level 2 and Level 3. The following table provides a description of the valuation technique, unobservable input, and qualitative information about the unobservable inputs for the Company’s assets and liabilities classified as Level 3 and measured at fair value on a recurring basis at December 31, 2018: Financial Instrument Valuation Technique Mortgage Servicing Rights Discounted cash flow Unobservable Input(s) Prepayment speed assumption Discount rate Range (Weighted Average) 80-515% (123%) 13%-14% (12.5%) The following table provides a description of the valuation technique, unobservable input, and qualitative information about the unobservable inputs for the Company’s assets and liabilities classified as Level 3 and measured at fair value on a recurring basis at December 31, 2017: Financial Instrument Valuation Technique Mortgage Servicing Rights Discounted cash flow Unobservable Input(s) Prepayment speed assumption Discount rate Range (Weighted Average) 103-412% (160%) 13%-15% (12.5%) Generally, any significant increases in the constant prepayment rate and discount rate utilized in the fair value measurement of the mortgage servicing rights will result in a negative fair value adjustment (and decrease in the fair value measurement). Conversely, a decrease in the constant prepayment rate and discount rate will result in a positive fair value adjustment (and increase in the fair value measurement). An increase in the weighted average life assumptions will result in a decrease in the constant prepayment rate and conversely, a decrease in the weighted average life will result in an increase of the constant prepayment rate. There were no assets or liabilities (excluding mortgage servicing rights) measured at fair value using significant unobservable inputs (Level 3) on a recurring basis during the year ended December 31, 2018. The following table provides a reconciliation of assets and liabilities (excluding mortgage servicing rights) measured at fair value using significant unobservable inputs (Level 3) on a recurring basis during the year ended December 31, 2017 (in thousands): Beginning balance, at fair value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . OTTI impairment losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sales, redemptions and principal payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Change in unrealized loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ending balance, at fair value. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2017 $ 347 — (347) — $ — 87 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Mortgage servicing rights are measured at fair value using significant unobservable input (Level 3) on a recurring basis and a reconciliation of this asset can be found in Note 6 – Mortgage Servicing Rights. The following table presents the balance of assets measured at fair value on a nonrecurring basis and the total losses resulting from these fair value adjustments (in thousands): Description Fair Value at December 31, 2018 Total Level 1 Level 2 OREO and repossessed assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . Impaired loans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 575 5,838 $— — $— — Level 3 $ 575 5,838 Description Fair Value at December 31, 2017 Total Level 1 Level 2 Level 3 OREO and repossessed assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . Impaired loans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 610 10,703 $— — $— — $ 610 10,703 There were no liabilities carried at fair value, measured on a recurring or nonrecurring basis, at December 31, 2018 or December 31, 2017. The following table provides a description of the valuation technique, observable input, and qualitative information about the unobservable inputs for the Company’s assets and liabilities classified as Level 3 and measured at fair value on a nonrecurring basis at December 31, 2018: Financial Instrument Valuation Technique(s) OREO Market approach Impaired loans Market approach Unobservable Input(s) Adjusted for difference between comparable sales Adjusted for difference between comparable sales Range (Weighted Average) 0-0% (0%) 0-100% (13%) The following table provides a description of the valuation technique, observable input, and qualitative information about the unobservable inputs for the Company’s assets and liabilities classified as Level 3 and measured at fair value on a nonrecurring basis at December 31, 2017: Financial Instrument Valuation Technique(s) OREO Market approach Impaired loans Market approach Unobservable Input(s) Adjusted for difference between comparable sales Adjusted for difference between comparable sales Range (Weighted Average) 0-0% (0%) 0-100% (8%) Note 12 – Earnings Per Share Basic earnings per common share is computed by dividing net income by the weighted-average number of common shares outstanding for the period, reduced for average unallocated ESOP shares and average unvested restricted stock awards. Unvested share-based awards containing non-forfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and are included in the computation of earnings per share pursuant to the two-class method, described in the Accounting Standard Codification for Earnings Per Share. Diluted earnings per common share reflect the potential dilution that could occur if securities or other contracts to issue common stock (such as stock awards and options) were exercised or converted to common stock or resulted in the issuance of common stock that then shared in the Company’s earnings. Diluted earnings per common share is computed by dividing net income by the weighted-average number of common shares outstanding for the period increased for the dilutive effect of unexercised stock options and unvested restricted stock awards. The dilutive effect of the unexercised stock options and unvested restricted stock awards is calculated under the treasury stock method utilizing the average market value of the Company’s stock for the period. 88 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Earnings per share are summarized for the periods presented in the following table (in thousands, except per share data): Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Weighted average number of shares outstanding, basic. . . . . . . . . . . . . . . . . . . . . . . Effect of potentially dilutive common shares. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Weighted average number of shares outstanding, diluted . . . . . . . . . . . . . . . . . . . . . Earnings per share, basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Earnings per share, diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . There were no anti-dilutive securities at December 31, 2018 or 2017. Year Ended December 31, 2018 $7,039 2,498 69 2,567 $ 2.82 $ 2.74 2017 $5,125 2,504 64 2,568 $ 2.05 $ 2.00 Note 13 – Employee Benefits The Company has a 401(k) retirement plan that allows employees to defer a portion of their salary into the 401(k) plan. The Company matches a portion of employees’ salary deferrals. 401(k) costs are accrued and funded on a current basis. The Company contributed $172,000 and $132,000 to the plan for the years ended December 31, 2018 and 2017, respectively. The Bank maintains a deferred compensation account for the benefit of Ms. Stewart, which account was established in 1994 in connection with an incentive plan which is no longer active. Ms. Stewart was fully vested in her benefits under this plan as of January 2005. Pursuant to the terms of the plan, payments in an amount equal to the fair market value of the assets in the deferred compensation account shall be made to Ms. Stewart (or to her designated beneficiary in the event of her death) in 120 equal monthly installments commencing on the last day of the month following the month in which her employment with the Bank is terminated. In the event of the death of Ms. Stewart and her designated beneficiary prior to the account being fully paid, the remaining value of the account shall be paid in a lump sum to the beneficiary’s estate. The assets in the deferred compensation account consist of cash which is held in a certificate of deposit at the Bank and earns interest at market rates. At December 31, 2018, the amounts held in the certificates of deposit at the Bank were $104,000, compared to $103,000 at December 31, 2017. The Bank maintains a nonqualified deferred compensation plan (the ‘‘NQDC Plan’’), which was effective on January 1, 2017. The purpose of the NQDC Plan is to provide a select group of management or highly-compensated employees of the Bank with an opportunity to defer the receipt of up to eighty percent (80%) of their annual base salary, bonus, performance-based compensation and any commission income and to assist the Company in attracting, retaining and motivating employees of high caliber and experience. In addition to elective deferrals, the Bank may make discretionary and other contributions to be credited to the account of any or all participants, subject to the vesting requirements set forth in the NQDC Plan. Discretionary contributions by the Bank become 100% vested upon the completion of three years of service from a participant’s effective date of participation in the NQDC Plan (with accelerated vesting upon death, disability or a change in control), while other Bank contributions (including matching contributions) vest at the rate of 20% per year, beginning with the participant’s two-year anniversary of his or her date of hire. The board of directors of the Bank agreed that in the event Ms. Stewart has a separation from service prior to January 1, 2020, the date she becomes vested in her discretionary contributions, then the Bank shall amend the NQDC Plan to provide for immediate vesting as of the date of the separation from service. During both the years ended December 31, 2018, and 2017, the Bank made discretionary contributions to the 2017 NQDC Plan in the amount of $75,000. Each participant’s deferred compensation account is credited with an investment return determined as if the account was invested in one or more investment funds. Each participant elects the investment funds in which his or her account shall be deemed to be invested. Distributions of vested account balances are made upon death, disability, separation from service, or a specified in-service date unforeseeable emergency. Distributions shall be 89 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements made in a single cash payment or, at the election of the participant, in annual installments for a period of up to ten (10) years in the case of a separation from service and in annual installments for a period of up to five (5) years in the case of an in-service distribution. The obligations of the Bank under the NQDC Plan are general unsecured obligations of the Bank to pay deferred compensation in the future to eligible participants in accordance with the terms of the NQDC Plan from the general assets of the Bank, although the Bank may establish a trust to hold amounts which the Bank may use to satisfy NQDC Plan distributions from time to time. Distributions from the NQDC Plan are governed by the Internal Revenue Code and the NQDC Plan. The Company may, at any time, in its sole discretion, terminate the NQDC Plan or amend or modify the NQDC Plan, in whole or in part, except that no such termination, amendment or modification shall have any retroactive effect to reduce any amounts deemed to be accrued and vested prior to such amendment. Supplemental Executive Retirement Plans. The Company maintains two supplemental executive retirement plans for the benefit of Ms. Stewart, which are intended to be unfunded, non-contributory defined benefit plans maintained primarily to provide her with supplemental retirement income. The first supplemental executive retirement plan (‘‘SERP 1’’) was effective as of August 2007. The second supplemental executive retirement plan (‘‘SERP 2’’) was effective as of December 30, 2011, at which time the benefits under SERP 1 were frozen. At that time, the Company also entered into a Confidentiality, Non-Competition, and Non-Solicitation Agreement with Ms. Stewart, which is discussed below. Under the terms of SERP 1, as amended, Ms. Stewart is entitled to receive $53,320 per year for life commencing on the first day of the month following her separation from service (as defined in SERP 1) for any reason from Sound Community Bank. No payments will be made under SERP 1 in the event of Ms. Stewart’s death and any payments that have commenced will cease upon death. In the event Ms. Stewart is involuntarily terminated in connection with a change in control (as defined in SERP 1), she will be entitled to receive the annual benefit described in the first sentence of this paragraph commencing upon such termination (subject to any applicable cutback for payments after a change in control as required by Section 280G of the Internal Revenue Code). Under the terms of SERP 2, as amended, upon Ms. Stewart’s termination of employment with Sound Community Bank for any reason other than death, she will be entitled to receive additional retirement benefits of $96,390 per year for life commencing on the first day of the month following the later of age 70 or her separation from service (as defined in SERP 2) from Sound Community Bank. In the event of Ms. Stewart’s death, her beneficiary will be entitled to a single lump sum payment within 90 days thereafter in an amount equal to the account value as of the death benefit valuation date, or approximately $1.2 million at December 31, 2018. If a change in control occurs (as defined in SERP 2), Ms. Stewart will receive her full retirement benefit under SERP 2 commencing upon the first day of the month following her separation from service from Sound Community Bank. Confidentiality, Non-Competition, and Non-Solicitation Agreement. On January 25, 2019, the Bank entered into an Amended and Restated Confidentiality, Non-competition, and Non-solicitation Agreement (the ‘‘Amended Non-compete Agreement’’) with Ms. Stewart. This Amended Non-compete Agreement amends and restates the Confidentiality, Non-Competition, and Non-Solicitation Agreement between the Bank and Ms. Stewart as originally adopted effective December 30, 2011, as amended and restated on November 23, 2015. The Amended Non-Compete Agreement provides that the term of the non-compete and non-solicitation periods applicable to Ms. Stewart is a fixed period of 36 months from the date of Ms. Stewart’s separation from service with the Company and the Bank (the ‘‘Restricted Period’’). Under the terms of the Amended Non-compete Agreement, upon Ms. Stewart’s termination of employment by the Bank for cause or voluntarily by Ms. Stewart (other than for good reason), Ms. Stewart will be entitled to receive a bi-monthly payment, in an amount equal to Three Thousand Five Hundred Forty-Two Dollars ($3,542), which amount shall be paid in equal bi-monthly payments during the Restricted Period beginning on the fifth day of the month following her separation from 90 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements service with the Bank. Upon Ms. Stewart’s termination of employment with the Bank for any reason other than set forth in the preceding sentence, she will be entitled to receive an amount equal to 150% of her then-base salary plus the average of her past three years short term bonus pay, or approximately $804,000 at December 31, 2018, payable in 12 monthly installments beginning on the first day of the month following her termination. If Ms. Stewart breaches any of the covenants contained in the Amended Non-compete Agreement, her right to any of the payments specified above after the date of the breach shall be forever forfeited. Notwithstanding the foregoing, under her Amended Non-compete Agreement, if Ms. Stewart’s employment with the Bank is involuntarily terminated or she terminates her employment with the Bank for good reason at any time within 24 months following a change in control, Ms. Stewart will be entitled to receive an amount equal to 150% of her then-base salary plus the average of her past three years short term bonus, payable in a lump sum. Stock Options and Restricted Stock The Company currently has two existing shareholder approved Equity Incentive Plans, the 2008 Equity Incentive Plan (the’’2008 Plan’’) and the Amended and Restated 2013 Equity Incentive Plan (the ‘‘2013 Plan’’). The Plans permit the grant of restricted stock, restricted stock units, stock options, and stock appreciation rights. The 2008 Plan expired in November 2018 and no further awards may be made under the 2008 Plan; provided, however, all awards outstanding under the 2008 Plan remain outstanding in accordance with their terms. Under the 2013 Plan, 181,750 shares of common stock were approved for awards for stock options and stock appreciation rights and 116,700 shares of common stock were approved for awards for restricted stock and restricted stock units. As of December 31, 2018, on an adjusted basis, awards for stock options totaling 261,876 shares and awards for restricted stock totaling 107,193 shares of Company common stock have been granted, net of any forfeitures, to participants in the Plan. During the years ended December 31, 2018 and 2017, share-based compensation expense totaled $273,000 and $523,000, respectively. Stock Option Awards The stock option awards granted to date under the 2008 Plan vest in 20 percent annual increments commencing one year from the grant date in accordance with the requirements of the 2008 Plan. The stock option awards granted to date under the 2013 Plan vest in equal annual installments of either two or four years. All of the options granted are exercisable for a period of 10 years from the date of grant, subject to vesting. The following is a summary of the Company’s stock option plan award activity during the period ended December 31, 2018: Outstanding at the beginning of the year . . . . . . . . . . . . . . . Granted. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Forfeited. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Expired. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shares 186,363 3,400 (49,266) (7,321) — Outstanding at December 31, 2018 . . . . . . . . . . . . . . . . . . . 133,176 Exercisable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101,788 Expected to vest, assuming a 0% forfeiture rate over the Weighted- Average Exercise Price $18.04 36.00 14.92 17.99 — 19.66 18.56 Weighted- Average Remaining Contractual Term In Years Aggregate Intrinsic Value 6.26 $2,977,279 5.89 5.60 1,716,306 1,423,658 vesting term . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31,388 $23.23 6.83 $ 292,648 As of December 31, 2018, there was $56,000 of total unrecognized compensation cost related to non-vested stock options granted under the Plan. The cost is expected to be recognized over the remaining weighted-average vesting period of 0.87 years. 91 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements The fair value of each option grant is estimated as of the grant date using the Black-Scholes option-pricing model. The fair value of options granted in 2018 was determined using the following weighted-average assumptions as of the grant date. Annual dividend yield. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Expected volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Risk-free interest rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Expected term . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Weighted-average grant date fair value per option granted . . . . . 2018 2017 1.72% 21.75% 2.95% 6.50 years $ 7.63 1.28% 22.99% 2.20% 6.50 years $ 6.62 Restricted Stock Awards The fair value of the restricted stock awards is equal to the fair value of the Company’s stock at the date of grant. Compensation expense is recognized over the vesting period that the awards are based. Outstanding restricted stock awards vest over periods of one-to-two years. The following is a summary of the Company’s non-vested restricted stock awards for the year ended December 31, 2018: Non-vested Shares Non-vested at January 1, 2018 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Granted. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Vested. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Forfeited. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Expired. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Non-vested at December 31, 2018 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Expected to vest assuming a 0% forfeiture rate over the vesting term . . . Shares 11,785 323 (10,907) (343) — 858 858 Weighted- Average Grant- Date Fair Value Per Share Aggregate Intrinsic Value Per Share $19.05 35.27 18.93 18.36 — 26.96 $26.96 $32.55 $32.55 As of December 31, 2018, there was $15,000 of unrecognized compensation cost related to non-vested restricted stock granted under the Plan. The cost is expected to be recognized over the weighted-average vesting period of 2.29 years. The total fair value of shares vested for the years ended December 31, 2018 and 2017 was $206,470 and $263,000, respectively. Employee Stock Ownership Plan In January 2008, the ESOP borrowed $1.2 million from the Company to purchase common stock of the Company. In August 2012, in conjunction with the Company’s conversion to a full stock company from the mutual holding company structure, the ESOP borrowed an additional $1.1 million from the Company to purchase common stock of the Company. The first loan for $1.2 million was paid off in 2017. The remaining loan for $1.1 million is being repaid principally by the Bank through contributions to the ESOP over a period of 10 years. The interest rate on the loan is fixed at 2.25%, per annum. As of December 31, 2018, the remaining balance of the ESOP loan was $362,000. Neither the loan balance nor the related interest expense is reflected on the consolidated financial statements. At December 31, 2018, the ESOP was committed to release 11,340 shares of the Company’s common stock to participants and held 34,020 unallocated shares remaining to be released in future years. The funds to purchase shares in the ESOP come from contributions the Bank makes twice a year to the Plan. For the year ended December 31, 2018, the ESOP trustee purchased 9,858 shares of the Company’s common stock for inclusion in the Plan. The fair value of the 171,254 restricted shares held by the ESOP trust was $5.6 million at December 31, 2018. ESOP compensation expense included in salaries and benefits was $652,000 and $640,000 for the years ended December 31, 2018 and 2017, respectively. 92 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Note 14 – Income Taxes The provision for income taxes at December 31, 2018 and 2017 was as follows (in thousands): Current . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Rate change . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . At December 31, 2018 $1,637 69 — $1,706 2017 $2,962 (203) 309 $3,068 On December 22, 2017, the U.S. Government enacted the Tax Act. For businesses, the Tax Act reduces the corporate federal income tax rate from a maximum of 35% to a flat 21% rate. The corporate income tax rate reduction was effective January 1, 2018. The Tax Act required a revaluation of the Company’s deferred tax assets and liabilities to account for the future impact of lower corporate tax rates and other provisions of the legislation. As a result of the Company’s revaluation, the Company’s deferred tax asset was reduced through an increase to the provision for income tax in 2017. A reconciliation of the provision for income taxes for the years ended December 31, 2018 and 2017, with amounts determined by applying the statutory U.S. federal income tax rate to income before income taxes, is as follows (dollars in thousands): Provision at statutory rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tax-exempt income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Rate change . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal Tax Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tax exempt rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Rate change . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Effective tax rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Year Ended December 31, 2018 $1,836 (79) — (51) $1,706 21.0% (0.9) — (0.6) 19.5% 2017 $2,786 (79) 309 52 $3,068 35.0% (1.0) 3.8 0.6 38.4% The following table reflects the temporary differences that gave rise to the components of the Company’s deferred tax assets at December 31, 2018 and 2017 (in thousands): Deferred tax assets Deferred compensation and supplemental retirement . . . . . . . . . . . . . . . . . . . . . . . . . . . Other, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equity based compensation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Intangible assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Allowance for loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total deferred tax assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred tax liabilities Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FHLB stock dividends. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unrealized gain on securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mortgage servicing rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred loan costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total deferred tax liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net deferred tax asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . At December 31, 2018 2017 $ 411 89 35 66 1,212 1,813 (59) (87) (30) (312) (161) (728) (1,377) 436 $ $ 342 66 84 53 844 1,389 (62) (87) (35) (258) (67) (380) (889) $ 500 93 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements As of December 31, 2018 and 2017, the Company had no unrecognized tax benefits. The Company recognizes interest accrued and penalties related to unrecognized tax benefits in ‘‘Provision for income taxes’’ in the Consolidated Statements of Income. During the years ended December 31, 2018 and 2017, the Company recognized no interest and penalties. The Company or its subsidiary files an income tax return in the U.S. federal jurisdiction. With few exceptions, the Company is no longer subject to U.S. federal income tax examinations by tax authorities for years before 2015. Note 15 – Minimum Regulatory Capital Requirements The Company is a bank holding company under the supervision of the Federal Reserve. Bank holding companies are subject to capital adequacy requirements of the Federal Reserve under the Bank Holding Company Act of 1956, as amended, and the regulations of the Federal Reserve Board, except that, pursuant to the Economic Growth, Regulatory Relief and Consumer Protection Act, effective August 30, 2018, a bank holding company with consolidated assets of less than $3 billion is generally not subject to the Federal Reserve’s capital regulations, which parallel the FDIC’s capital regulations. If the Company were subject to regulatory guidelines for bank holding companies with $3.0 billion or more in assets at December 31, 2018, and 2017, the Company would have exceeded all regulatory requirements. The Bank is a state-chartered, federally insured institution and thereby is subject to the capital requirements established by the FDIC. Failure to meet minimum capital requirements can initiate certain mandatory and, possibly, additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital regulations that involve quantitative measures of their assets, liabilities, and certain off-balance- sheet items as calculated under regulatory accounting practices. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Prompt corrective action provisions are not applicable to bank holding companies. Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier 1 capital to risk-weighted assets (as defined in the regulations) and of Tier 1 capital to average assets. As of December 31, 2018, according to the most recent notification from the FDIC, the Bank was categorized as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since the notification that management believes have changed the Bank’s category. The Bank’s actual capital amounts (in thousands) and ratios as of December 31, 2018 and 2017 are presented in the following table: Actual Minimum Capital Requirements Minimum Required to be Well-Capitalized Under Prompt Corrective Action Provisions As of December 31, 2018 Tier 1 Capital to total adjusted assets(1) . . . . . . . . . Common Equity Tier 1 risk-based capital ratio(2) . . Tier 1 Capital to risk-weighted assets(2) . . . . . . . . . Total Capital to risk-weighted assets(2) . . . . . . . . . . As of December 31, 2017 Tier 1 Capital to total adjusted assets(3) . . . . . . . . . Common Equity Tier 1 risk-based capital ratio(4) . . Tier 1 Capital to risk-weighted assets(4) . . . . . . . . . Total Capital to risk-weighted assets(4) . . . . . . . . . . Amount Ratio Amount Ratio Amount Ratio $69,685 69,685 69,685 $75,874 $62,432 62,432 62,432 $67,868 9.73% $28,659 26,665 11.76 11.76 35,553 12.80% $47,404 10.10% $24,721 23,354 12.03 12.03 31,138 13.08% $41,518 4.0% 4.5 6.0 8.0% 4.0% 4.5 6.0 8.0% $35,824 38,516 47,404 $59,255 $30,902 33,733 41,518 $51,897 5.0% 6.5 8.0 10.0% 5.0% 6.5 8.0 10.0% (1) Based on total adjusted assets of $716,475 at December 31, 2018. 94 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements (2) Based on risk-weighted assets of $592,551 at December 31, 2018. (3) Based on total adjusted assets of $618,035 at December 31, 2017. (4) Based on risk-weighted assets of $518,970 at December 31, 2017. In addition to the minimum common equity Tier 1 capital ratio (‘‘CET1’’), the Bank must maintain a capital conservation buffer consisting of additional CET1 capital above the required minimum levels in order to avoid limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses based on percentages of eligible retained income that could be utilized for such actions. This capital conservation buffer requirement was phased in beginning in January 2016 at an amount more than 0.625% of risk-weighted assets and increased each year to an amount more than 2.5% of risk-weighted assets when fully implemented on January 1, 2019. At December 31, 2018, the conservation buffer requirement was 1.875% and the Bank’s actual conservation buffer was 4.80% . 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. If Sound Financial Bancorp was subject to regulatory guidelines for bank holding companies with $3.0 billion or more in assets, at December 31, 2018 Sound Financial Bancorp would have exceeded all regulatory capital requirements. The estimated regulatory capital ratios calculated for Sound Financial Bancorp as of December 31, 2018 were 9.85% for Tier 1 leverage-based capital, 11.92% for both Common Equity Tier 1 risk-based capital, Tier 1 Capital to risk-based assets and 12.96% for total risk-based capital. Note 16 – Concentrations of Credit Risk Most of the Company’s business activity is with clients located in the state of Washington. A substantial portion of the loan portfolio is represented by real estate loans throughout western Washington. The ability of the Company’s debtors to honor their contracts is dependent upon the real estate and general economic conditions in the area. Loans to one borrower are generally limited by federal banking regulations to 15% of the Company’s unimpaired capital and surplus. Note 17 – Commitments and Contingencies The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its clients. These financial instruments generally represent a commitment to extend credit in the form of loans. The instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The Company’s exposure to credit loss, in the event of nonperformance by the other party to the financial instrument for commitments to extend credit, is represented by the contractual notional amount of those instruments. The Company uses the same credit policies in making commitments as it does for on-balance-sheet instruments. Commitments to extend credit are agreements to lend to a client as long as there is no violation of any condition established by the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Because many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each client’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if it is deemed necessary by the Company, is based on management’s credit evaluation of the client. 95 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Financial instruments whose contract amount represents credit risk were as follow (in thousands): At December 31, 2018 2017 Commitments to make loans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unfunded construction commitments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unused lines of credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Irrevocable letters of credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,176 60,632 45,315 1,460 Total loan commitments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $110,583 $ 1,689 39,400 32,440 1,400 $74,929 At December 31, 2018, fixed rate loan commitments totaled $4.1 million and had a weighted-average interest rate of 4.93%. At December 31, 2017, fixed rate loan commitments totaled $3.4 million and had a weighted-average interest rate of 4.29%. Commitments for credit may expire without being drawn upon. Therefore, the total commitment amount does not necessarily represent future cash requirements of the Company. These commitments are not reflected in the financial statements. At December 31, 2018 and 2017 both, the Company had letters of credit issued by the FHLB with a notional amount of $14.5 million in order to secure Washington State Public Funds. In the ordinary course of business, the Company sells loans without recourse that may have to be subsequently repurchased due to defects that occurred during the origination of the loan. The defects are categorized as documentation errors, underwriting errors, early payment defaults, and fraud. When a loan sold to an investor without recourse fails to perform, the investor will typically review the loan file to determine whether defects in the origination process occurred. If a defect is identified, the Company may be required to either repurchase the loan or indemnify the investor for losses sustained. If there are no defects, the Company has no commitment to repurchase the loan. As of December 31, 2018 and 2017, the maximum amount of these guarantees totaled $376.5 million and $392.6 million, respectively. These amounts represent the unpaid principal balances of the Company’s loans serviced for others’ portfolios. There were no loans repurchased during the year ended December 31, 2018 and one loan with the amount of $135,000 repurchased from Fannie Mae during the year during the year ended December 31, 2017. The Company pays certain medical, dental, prescription, and vision claims for its employees, on a self-insured basis. The Company has purchased stop-loss insurance to cover claims that exceed stated limits and has recorded estimated reserves for the ultimate costs for both reported claims and claims incurred but not reported, which were not considered significant at December 31, 2017. At December 31, 2018, the Company recorded $239,000 in stop loss medical insurance claim which is included in other assets on the consolidated statements of financial condition. At various times, the Company may be the defendant in various legal proceedings arising in connection with its business. It is the opinion of management that the financial position and the results of operations of the Company will not be materially adversely affected by the outcome of these legal proceedings and that adequate provision has been made in the accompanying consolidated financial statements. 96 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Note 18 – Parent Company Financial Information The Balance Sheets, Statements of Income, and Statements of Cash Flows for Sound Financial Bancorp (Parent Only) are presented below (dollars in thousands): Balance sheets Assets Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment in Sound Community Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . December 31, 2018 2017 $ 18 70,785 824 $71,627 $ 882 63,535 743 $65,160 Liabilities and Stockholders’ Equity Other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ — $ — Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — — Stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71,627 65,160 Total liabilities and stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $71,627 $65,160 Statements of Income Year Ended December 31, 2018 2017 Other expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (310) $ (243) Income before income tax benefit and equity in undistributed net Income of subsidiary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax benefit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equity in undistributed earnings of subsidiary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (310) 65 7,284 (243) 83 5,285 Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $7,039 $5,125 Statements of Cash Flows Cash flows from operating activities: Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjustments to reconcile net income to net cash provided by operating activities Other, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Change in undistributed equity of subsidiary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash used in operating activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash flows from investing activities: ESOP shares released . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash provided by investing activities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash flows from financing activities: Dividends paid. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends received from subsidiary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stock options exercised. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash used in financing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net decrease in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash and cash equivalents at beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Year Ended December 31, 2018 2017 $ 7,039 $ 5,125 (65) (7,284) (310) — — (1,367) 711 102 (554) (864) 882 (83) (5,285) (243) 671 671 (1,505) — 43 (1,462) (1,034) 1,916 Cash and cash equivalents at end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 18 $ 882 97 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Note 19 – Revenue from Contracts with Customers All of the Company’s revenue from contracts with customers in the scope of ASC 606 - Revenue from Contracts with Customers (‘‘ASC 606’’) is recognized in Noninterest Income with the exception of the net loss on OREO and repossessed assets, which is included in Noninterest Expense. The following table presents the Company’s sources of Noninterest Income for the year ended December 31, 2018 and 2017 (in thousands). Items outside of the scope of ASC 606 are noted as such. Year Ended December 31, 2018 2017 Noninterest income: Service charges and fee income Account maintenance fees. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Transaction-based and overdraft service charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Debit/ATM interchange fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Credit card interchange fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loan fees(a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other fees(a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total service charges and fee income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Earnings on cash surrender value of bank-owned life insurance(a). . . . . . . . . . . . . . . . . . . Mortgage servicing income(a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net gain on sale of loans(a). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other income(a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total noninterest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 192 481 927 40 188 48 1,876 320 562 1,258 490 $ 178 417 912 32 296 60 1,895 327 566 1,071 — $4,506 $3,859 (a) Not within scope of ASC 606 Account maintenance fees and transaction-based and overdraft service charges The Company earns fees from its customers for account maintenance, transaction-based and overdraft services. Account maintenance fees consist primarily of account fees and analyzed account fees charged on deposit accounts on a monthly basis. The performance obligation is satisfied and fees are recognized on a monthly basis as the service period is completed. Transaction-based fees and overdraft service fees on deposit accounts are charged to deposit customers for specific services provided to the customer, such as non-sufficient funds, overdraft, and wire services. The performance obligation is completed as the transaction occurs and the fees are recognized at the time each specific service is provided to the customer. Debit/ATM and credit card interchange income Debit/ATM interchange income represent fees earned when a debit card issued by the Bank is used for a transaction. The Bank earns interchange fees from debit cardholder transactions through the MasterCard payment network. Interchange fees from cardholder transactions represent a percentage of the underlying transaction value and are recognized daily, concurrently with the transaction processing services provided to the cardholder. The performance obligation is satisfied and the fees are earned when the cost of the transaction is charged to the cardholders’ account. Certain expenses directly associated with the debit card are recorded on a net basis with the interchange income. The Company utilizes a third party agency relationship to brand credit cards with fees for originating new accounts paid by the issuing bank. Credit card interchange income represents fees earned when a credit card is issued by the third party agent. Similar to debit card interchange fees, the Bank earns an interchange fee for each transaction made with Sound Community Bank’s branded credit cards. The performance obligation is satisfied and the fees are earned when the cost of the transaction is charged to the cardholders’ credit card. Certain expenses and rebates directly related to the credit card interchange contract are recorded net of the interchange income. 98 SOUND FINANCIAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Net loss on OREO and repossessed assets We record a gain or loss from the sale of other real estate owned when control of the property transfers to the buyer, which generally occurs at the time of an executed deed of trust. When the Bank finances the sale of other real estate owned to the buyer, the Company assesses whether the buyer is committed to perform their obligations under the contract and whether collectability of the transaction price is probable. Once these criteria are met, the other real estate owned asset is derecognized and the gain or loss on sale is recorded upon the transfer of control of the property to the buyer. In determining the gain or loss on sale, we adjust the transaction price and related gain or loss on sale if a significant financing component is present. The Company had a loss on the sale of OREO of $74,000 and $94,000 for the years ended December 31, 2018 and 2017, respectively, included in Noninterest Expense. Note 20 – Subsequent Events On January 28, 2019, the Company declared a quarterly cash dividend of 0.14 per common share, payable on February 22, 2019 to shareholders of record at the close of business February 8, 2019. On January 28, 2019, the Company announced that its Board of Directors authorized a stock repurchase program. Under this repurchase program, the Company may repurchase up to $1,750,000 of the Company’s outstanding shares, in the open market, based on prevailing market prices, or in privately negotiated transactions, over a period beginning on January 31, 2019 continuing until the earlier of the completion of the repurchase or the next six (6) months, depending upon market conditions. The Company’s Board of Directors also authorized management to enter into a trading plan with registered broker-dealer in accordance with Rule 10b5-1 of the Securities Exchange Act of 1934, as amended, to facilitate repurchases of its common stock pursuant to the above mentioned stock repurchase program. 99 Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure None. Item 9A. Controls and Procedures (a) Evaluation of Disclosure Controls and Procedures An evaluation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the ‘‘Exchange Act’’)) as of December 31, 2018, was carried out under the supervision and with the participation of the our Chief Executive Officer, Chief Financial Officer and several other members of our senior management team within the 90-day period preceding the filing of this annual report. Our Chief Executive Officer and Chief Financial Officer concluded that, as of December 31, 2018, our disclosure controls and procedures were effective in ensuring that the information required to be disclosed by us in the reports we file or submit under the Exchange Act is (i) accumulated and communicated to our management (including our Chief Executive Officer and Chief Financial Officer) in a timely manner, and (ii) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. We intend to continually review and evaluate the design and effectiveness of the Company’s disclosure controls and procedures and to improve the Company’s controls and procedures over time and to correct any deficiencies that we may discover in the future. The goal is to ensure that senior management has timely access to all material financial and non-financial information concerning the Company’s business. While we believe the present design of the disclosure controls and procedures is effective to achieve its goal, future events affecting its business may cause the Company to modify its disclosure controls and procedures. The Company does not expect that its disclosure controls and procedures will prevent all error and all fraud. A control procedure, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control procedure are met. Because of the inherent limitations in all control procedures, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any control procedure also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control procedure, misstatements due to error or fraud may occur and not be detected. (b) Internal Control Over Financial Reporting MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING The management of Sound Financial Bancorp is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13a-15(f). The Company’s internal control over financial reporting is a process designed to provide reasonable assurance to the Company’s management and board of directors regarding the reliability of financial reporting and the preparation of the financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America. There are inherent limitations in the effectiveness of any system of internal control over financial reporting, including the possibility of human error and circumvention or overriding of controls. Accordingly, even an effective system of internal control over financial reporting can provide only reasonable assurance with respect to financial statement preparation. Projections of any evaluation of effectiveness to future periods are subject to the risks that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate. Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2018. In making this assessment, it used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework (2013). Based on this assessment, we concluded that, as of December 31, 2018, the Company’s internal control over financial reporting was effective based on those criteria. 100 Moss Adams, LLP, the Company’s independent registered public accounting firm that audited our consolidated financial statements at and, for, the year ended December 31, 2018, included in this annual report on Form 10-K, has issued an attestation report on the effectiveness of the Company’s internal control over financial reporting. The attestation report is included above in Item 8. (c) Changes in Internal Controls over Financial Reporting As required by Rule 13a-15(d), our management, including our Chief Executive Officer and Chief Financial Officer, also conducted an evaluation of our internal control over financial reporting to determine whether any changes occurred during quarter ended December 31, 2018 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. There were no changes in our internal controls over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that occurred during the quarter ended December 31, 2018, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Item 9B. Other Information None. 101 PART III Item 10. Directors, Executive Officers and Corporate Governance Directors Information concerning the Company’s directors is incorporated herein by reference from the Company’s definitive proxy statement for its Annual Meeting of Shareholders to be held in May 2019, a copy of which will be filed with the SEC not later than 120 days after the close of the fiscal year. Executive Officers Information concerning the executive officers of the Company and the Bank is contained under the heading ‘‘Executive Officers’’ under Part I, Item 1 of this Form 10-K and is incorporated herein by reference. Section 16(a) Beneficial Ownership and Reporting Compliance Section 16(a) of the Securities Exchange Act of 1934, as amended, requires our directors and executive officers, and persons who own more than 10% of Sound Financial Bancorp’s common stock to report to the SEC their initial ownership of Sound Financial Bancorp’s common stock and any subsequent changes in that ownership. Specific due dates for these reports have been established by the SEC, and Sound Financial Bancorp is required to disclose in its proxy statement any late filings or failures to file. To our knowledge, based solely on a review of the copies of reports furnished to us and written representations relative to the filing of certain forms, all Section 16(a) filing requirements applicable to our executive officers, directors and greater than 10% beneficial owners were met for transactions in our common stock during 2018. Code of Ethics We have adopted a code of ethics that applies to our principal executive officer, principal financial officer, principal accounting officer, and person performing similar functions, and to all of our other employees and our directors. You may obtain a copy of the code of ethics free of charge by writing to the Corporate Secretary of Sound Financial Bancorp, 2400 3rd Avenue, Suite 150, Seattle, Washington, 98121 or by calling (206) 448-0884. In addition, the code of ethics is available on our website at www.soundcb.com under ‘‘Investor Relations – Governance.’’ Corporate Governance Nominating Procedures. There have been no material changes to the procedures by which shareholders may recommend nominees to our Board of Directors since last disclosed to shareholders. Audit Committee and Audit Committee Financial Expert. Sound Financial Bancorp has an Audit Committee that is appointed by the Board of Directors to provide assistance to the Board in fulfilling its oversight responsibility relating to the integrity of our consolidated financial statements and the financial reporting processes, the systems of internal accounting and financial controls, compliance with legal and regulatory requirements, the annual independent audit of our consolidated financial statements, the independent auditors’ qualifications and independence, the performance of our internal audit function and independent auditors and any other areas of potential financial risk to Sound Financial Bancorp specified by its Board of Directors. The Audit Committee also is responsible for the appointment, retention and oversight of our independent auditors, including pre-approval of all audit and non-audit services to be performed by the independent auditors. During 2018, the Audit Committee was comprised of Directors Jones (chair), Carney, Cook, Riojas and Haddad, each of whom is ‘‘independent’’ as that term is defined for audit committee members in the Nasdaq Rules. The Board of Directors has determined that Director Jones is an ‘‘audit committee financial expert’’ as defined in Item 407(e) of Regulation S-K of the Securities and Exchange Commission and that all of the Audit Committee members meet the financial literacy requirements under the NASDAQ listing standards. Additional information concerning the Audit Committee is incorporated herein by reference from the Company’s definitive proxy statement for its Annual Meeting of Shareholders to be held in May 2019 (except for information contained under the heading ‘‘Report of the Audit Committee’’), a copy of which will be filed with the SEC not later than 120 days after the close of the fiscal year. 102 Item 11. Executive Compensation Information concerning executive compensation is incorporated herein by reference from the Company’s definitive proxy statement for its Annual Meeting of Shareholders to be held in May 2019 (except for information contained under the heading ‘‘Report of the Audit Committee’’), a copy of which will be filed with the SEC not later than 120 days after the close of the fiscal year. Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters Information concerning security ownership of certain beneficial owners and management is incorporated herein by reference from the Company’s definitive proxy statement for its Annual Meeting of Shareholders to be held in May 2019, a copy of which will be filed with the SEC not later than 120 days after the close of the fiscal year. The Company is not aware of any arrangements, including any pledge by any person of securities of the Company, the operation of which may at a subsequent date result in a change in control of Sound Financial Bancorp, Inc. Equity Compensation Plan Information. The following table sets forth information as of December 31, 2018 with respect to the Company’s equity compensation plans, all of which were approved by the Company’s shareholders. Plan Category Number of securities to be issued upon exercise of outstanding options, warrants and rights Weighted average exercise price of outstanding options, warrants and rights Number of securities remaining available for future issuance under equity compensation plan Equity Incentive Plan approved by security holders . . . . . . . . . . 101,788 Equity Incentive Plan not approved by security holders . . Total . . . . . . . . . . . . . . . . . . . . . . . — 101,788 $18.56 — $18.56 (1) — — (1) Total number of shares available for issuance for stock awards, other than awards of stock options and stock appreciation rights. Item 13. Certain Relationships and Related Transactions, and Director Independence Information concerning certain relationships and related transactions, our independent directors and our audit and nominating committee charters is incorporated herein by reference from the Company’s definitive proxy statement for its Annual Meeting of Shareholders to be held in May 2019, a copy of which will be filed with the SEC not later than 120 days after the close of the fiscal year. Item 14. Principal Accounting Fees and Services Information concerning principal accountant fees and services is incorporated herein by reference from the Company’s definitive proxy statement for its Annual Meeting of Shareholders to be held in May 2019 (except for information contained under the heading ‘‘Report of the Audit Committee’’) a copy of which will be filed with the SEC not later than 120 days after the close of the fiscal year. 103 PART IV Item 15. Exhibits and Financial Statement Schedules (a)(1) List of Financial Statements The following are contained in Item 8: Report of Independent Registered Public Accounting Firm Consolidated Balance Sheets at December 31, 2018 and 2017 Consolidated Statements of Income for the Years Ended December 31, 2018 and 2017 Consolidated Statements of Comprehensive Income for the Years December 31, 2018 and 2017 Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2018 and 2017 Consolidated Statements of Cash Flows for the Years Ended December 31, 2018 and 2017 Notes to Consolidated Financial Statements (a)(2) List of Financial Statement Schedules: All financial statement schedules have been omitted as the information is not required under the related instructions or is not applicable. (a)(3) List of Exhibits: (b) Exhibits: 104 Exhibits: 3.1 3.2 4.0 10.1 10.2 10.3 10.4 10.5 10.6 10.7 10.8 10.9 10.10 10.11 10.12 10.13 10.14 EXHIBIT INDEX Articles of Incorporation of Sound Financial Bancorp, Inc. (incorporated herein by reference to the Registration Statement on Form S-1 filed with the SEC on March 27, 2012 (File No. 333-180385)) Bylaws of Sound Financial Bancorp, Inc . (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on February 3, 2015 (File No. 001-35633)) Form of Common Stock Certificate of Sound Financial Bancorp, Inc . (incorporated herein by reference to the Registration Statement on Form S-1 filed with the SEC on March 27, 2012 (File No. 333-180385)) Form of Amended and Restated Employment Agreement dated August 30, 2016, among Sound Financial Bancorp, Inc., Sound Community Bank and Laura Lee Stewart (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on September 1, 2016 (File No. 001-35633)) Amended and Restated Supplemental Executive Retirement Agreement by and between Sound Community Bank and Laura Lee Stewart (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on November 27, 2015 (File No. 001-35633)) Amended and Restated Long Term Compensation Agreement by and between Sound Community Bank and Laura Lee Stewart (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on November 27, 2015 (File No. 001-35633)) Amended and Restated Confidentiality, Non-Competition and Non-Solicitation Agreement by and between Sound Community Bank and Laura Lee Stewart (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on November 27, 2015 (File No. 001-35633)) 2008 Equity Incentive Plan (incorporated herein by reference to the Annual Report on Form 10-K filed with the SEC on March 30, 2009 (File No. 000-52889)) Forms of Incentive Stock Option Agreement, Non-Qualified Stock Option Agreement and Restricted Stock Agreements under the 2008 Equity Incentive Plan (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on January 29, 2009 (File No. 000-52889)) Summary of Annual Bonus Plan (incorporated herein by reference to the Registration Statement on Form SB-2 filed with the SEC on September 20, 2007 (File No. 333-146196)) 2013 Equity Inventive Plan (included as Exhibit 10.13 to the Registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30,2013 and incorporated herein by reference (File No. 001-35633)) Form of Incentive Stock Option Agreement, Non-Qualified Stock Option Agreement and Restricted Stock Agreement under the 2013 Equity Incentive Plan (included as Exhibit 10.14 to the Registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2013 and incorporated herein by reference (File No. 001-35633)) Amended and Restated Change of Control Agreement dated June 21, 2016, by and among Sound Financial Bancorp, Inc., Sound Community Bank and Matthew P. Deines (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on June 24, 2016 (File No. 001-35633)) Change of Control Agreement dated June 21, 2016, by and among Sound Financial Bancorp, Inc., Sound Community Bank and Elliott Pierce (included as Exhibit 10.11 to the Registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2017 and incorporated herein by reference (File No. 001-35633)) Adoption Agreement for the Sound Community Bank Nonqualified Deferred Compensation Plan (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on March 24, 2017 (File No. 001-35633)) The Sound Community Bank Nonqualified Deferred Compensation Plan (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on March 24, 2017 (File No. 001-35633)) Change of Control Agreement dated June 22, 2016, by and among Sound Financial Bancorp, Inc., Sound Community Bank and Christina Gehrke (included as Exhibit 10.14 to the Registrants Quarterly Report on Form 10-Q for the quarter ended September 30, 2017 and incorporated herein by reference (File No. 001-35633)) 105 Exhibits: 10.15 10.16 10.17 10.18 10.19 10.20 11 21 23 24 31.1 31.2 32 101 Separation Agreement and Release of All Claims entered into between Mathew P. Deines and Sound Community Bank)(incorporated herein by reference to the Current Report on Form 8-K/A filed with the SEC on April 12, 2018 (File No. 001-35633)) Change of Control Agreement dated October 25, 2018, by and among Sound Financial Bancorp, Inc., Sound Community Bank and Daphne Kelley (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on October 26, 2018 (File No. (001-35633)) Change of Control Agreement dated October 25, 2018, by and among Sound Financial Bancorp, Inc., Sound Community Bank and Heidi Sexton (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on October 26, 2018 (File No. (001-35633)) Credit Union of the Pacific Incentive Compensation Achievement Plan, dated January 1, 1994 Amended and Restated Employment Agreement dated January 25, 2019, by and between Sound Community Bank and Laura Lee Stewart (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on January 30, 2019 (File No. 001-35633)) Amended and Restated Confidentiality, Non-Competition, and Non-Solicitation Agreement dated January 25, 2019, by and between Sound Community Bank and Laura Lee Stewart (incorporated herein by reference to the Current Report on Form 8-K filed with the SEC on January 30, 2019 (File No. 001-35633)) Statement re computation of per share earnings (See Note 12 of the Notes to Consolidated Financial Statements contained in Item 8, Part II of this Annual Report on Form 10-K.) Subsidiaries of Registrant (incorporated herein by reference to the Registration Statement on Form SB-2 filed with the SEC on September 20, 2007 (File No. 333-146196)) Consent of Moss Adams LLP Power of Attorney (set forth on signature page) Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. Filed herewith. Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. Filed herewith. Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. Furnished herewith. Interactive Data File (c) Financial Statements Schedules - None Item 16. Form 10-K Summary - None 106 Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. SIGNATURES Date: March 14, 2019 By: /s/ Laura Lee Stewart Sound Financial Bancorp, Inc. Laura Lee Stewart, President and Chief Executive Officer (Duly Authorized Representative) POWER OF ATTORNEY We, the undersigned officers and directors of Sound Financial Bancorp, Inc., hereby severally and individually constitute and appoint Laura Lee Stewart and Daphne D. Kelley, and each of them, the true and lawful attorneys and agents of each of us to execute in the name, place and stead of each of us (individually and in any capacity stated below) any and all amendments to this Annual Report on Form 10-K and all instruments necessary or advisable in connection therewith and to file the same with the Securities and Exchange Commission, each of said attorneys and agents to have the power to act with or without the others and to have full power and authority to do and perform in the name and on behalf of each of the undersigned every act whatsoever necessary or advisable to be done in the premises as fully and to all intents and purposes as any of the undersigned might or could do in person, and we hereby ratify and confirm our signatures as they may be signed by our said attorneys and agents or each of them to any and all such amendments and instruments. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. /s/ Laura Lee Stewart /s/ Tyler K. Myers Laura Lee Stewart, President and Director (Principal Executive Officer) Date: March 14, 2019 Tyler K. Myers, Chairman of the Board Date: March 14, 2019 /s/ David S. Haddad, Jr. David S. Haddad, Jr., Director Date: March 14, 2019 /s/ Debra Jones Debra Jones, Director Date: March 14, 2019 /s/ James E. Sweeney James E. Sweeney, Director Date: March 14, 2019 /s/ Daphne D. Kelley Daphne D. Kelley, Executive Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) Date: March 14, 2019 /s/ Robert F. Carney Robert F. Carney, Director Date: March 14, 2019 /s/ Rogelio Riojas Rogelio Riojas, Director Date: March 14, 2019 /s/ Kathleen B. Cook Kathleen B. Cook, Director Date: March 14, 2019 107 CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM We consent to the incorporation by reference in these Registration Statements (Form S-8, Nos. 333-184223, 333-192345, and 333-225548) of Sound Financial Bancorp, Inc. of our report dated March 14, 2019, with respect to the consolidated financial statements and the effectiveness of internal control over financial reporting of Sound Financial Bancorp, Inc. and Subsidiary, appearing in this annual report on Form 10-K for the year ended December 31, 2018. EXHIBIT 23.1 /s/ Moss Adams, LLP Everett, Washington March 14, 2019 EXHIBIT 31.1 I, Laura Lee Stewart, certify that: CERTIFICATION 1. I have reviewed this annual report on Form 10-K of Sound Financial Bancorp, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f) for the registrant and have: a. Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b. Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; c. Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d. Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth quarter in the case of an annual report)that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and 5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions): a. All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting, which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and b. Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting. Date: March 14, 2019 By: /s/ Laura Lee Stewart Laura Lee Stewart President/Chief Executive Officer (Principal Executive Officer) EXHIBIT 31.2 I, Daphne D. Kelley, certify that: CERTIFICATION 1. I have reviewed this annual report on Form 10-K of Sound Financial Bancorp, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f) for the registrant and have: a. Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b. Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; c. Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d. Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth quarter in the case of an annual report)that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and 5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions): a. All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting, which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and b. Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting. Date: March 14, 2019 By: /s/ Daphne D. Kelley Daphne D. Kelley Executive Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) EXHIBIT 32 SECTION 1350 CERTIFICATION Each of the undersigned hereby certifies in his or her capacity as an officer of Sound Financial, Inc. (the ″Registrant″) that the Annual Report of the Registrant on Form 10-K for the year ended December 31, 2018 fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 and that the information contained in the report fairly presents, in all material respects, the consolidated financial condition of the Registrant at the end of such period and the results of operations of the Registrant for such period. Date: March 14, 2019 By: /s/ Laura Lee Stewart Laura Lee Stewart President and Chief Executive Officer Date: March 14, 2019 By: /s/ Daphne D. Kelley Daphne D. Kelley Executive Vice President and Chief Financial Officer SOUND FINANCIAL BANCORP, INC IMPORTANT INFORMATION Independent Auditors Moss Adams LLP 2707 Colby Avenue Everett, WA 98201 Special Counsel Silver, Freedman, Taff & Tiernan LLP 3299 K Street NW, Suite 100 Washington, D.C. 20007 Transfer Agent Shareholders should direct inquiries concerning their stock, change of name, address or ownership, report lost certificates or consolidate accounts to our transfer agent at 877-830-4936 or write: Broadridge Corporate Issuer Solutions, Inc. 1717 Arch Street, Suite 1300 Philadelphia, PA 19103 SOUND FINANCIAL BANCORP, INC (cid:38)(cid:82)(cid:85)(cid:83)(cid:82)(cid:85)(cid:68)(cid:87)(cid:72)(cid:3)(cid:50)(cid:73)(cid:73)(cid:76)(cid:70)(cid:72)(cid:86) 2400 3rd Avenue Suite 150 (cid:54)(cid:72)(cid:68)(cid:87)(cid:87)(cid:79)(cid:72)(cid:15)(cid:3)(cid:58)(cid:36)(cid:3)(cid:28)(cid:27)(cid:20)(cid:21)(cid:20) SOUND COMMUNITY BANK: BRANCH OFFICE LOCATIONS Port Angeles Sequim Creekside Port Ludlow Mountlake Terrace Belltown Madison Park Downtown Seattle (cid:53)(cid:72)(cid:70)(cid:92)(cid:70)(cid:79)(cid:72)(cid:71)(cid:3)(cid:51)(cid:68)(cid:83)(cid:72)(cid:85)(cid:3) used for printing (cid:87)(cid:75)(cid:76)(cid:86)(cid:3)(cid:36)(cid:81)(cid:81)(cid:88)(cid:68)(cid:79)(cid:3)(cid:53)(cid:72)(cid:83)(cid:82)(cid:85)(cid:87) Tacoma University Place Sequim (cid:25)(cid:23)(cid:24)(cid:3)(cid:58)(cid:17)(cid:3)(cid:58)(cid:68)(cid:86)(cid:75)(cid:76)(cid:81)(cid:74)(cid:87)(cid:82)(cid:81)(cid:3)(cid:54)(cid:87)(cid:17) (cid:54)(cid:72)(cid:84)(cid:88)(cid:76)(cid:80)(cid:15)(cid:3)(cid:58)(cid:36)(cid:3)(cid:3) (cid:28)(cid:27)(cid:22)(cid:27)(cid:21) Madison Park (cid:22)(cid:20)(cid:19)(cid:20)(cid:3)(cid:40)(cid:17)(cid:3)(cid:48)(cid:68)(cid:71)(cid:76)(cid:86)(cid:82)(cid:81)(cid:3)(cid:54)(cid:87)(cid:85)(cid:72)(cid:72)(cid:87)(cid:3)(cid:3)(cid:3) (cid:54)(cid:72)(cid:68)(cid:87)(cid:87)(cid:79)(cid:72)(cid:15)(cid:3)(cid:58)(cid:36)(cid:3)(cid:3)(cid:28)(cid:27)(cid:20)(cid:20)(cid:21) Downtown Seattle (cid:21)(cid:19)(cid:19)(cid:20)(cid:3)(cid:24)(cid:87)(cid:75)(cid:3)(cid:36)(cid:89)(cid:72)(cid:81)(cid:88)(cid:72)(cid:3)(cid:3)(cid:3) (cid:54)(cid:72)(cid:68)(cid:87)(cid:87)(cid:79)(cid:72)(cid:15)(cid:3)(cid:58)(cid:36)(cid:3)(cid:3)(cid:28)(cid:27)(cid:20)(cid:21)(cid:20) Belltown (cid:21)(cid:23)(cid:19)(cid:19)(cid:3)(cid:22)(cid:85)(cid:71)(cid:3)(cid:36)(cid:89)(cid:72)(cid:81)(cid:88)(cid:72)(cid:15)(cid:3) (cid:54)(cid:88)(cid:76)(cid:87)(cid:72)(cid:3)(cid:20)(cid:19)(cid:19) (cid:54)(cid:72)(cid:68)(cid:87)(cid:87)(cid:79)(cid:72)(cid:15)(cid:3)(cid:58)(cid:36)(cid:3)(cid:28)(cid:27)(cid:20)(cid:21)(cid:20) Sequim Creekside (cid:28)(cid:28)(cid:19)(cid:3)(cid:40)(cid:17)(cid:3)(cid:58)(cid:68)(cid:86)(cid:75)(cid:76)(cid:81)(cid:74)(cid:87)(cid:82)(cid:81)(cid:3)(cid:54)(cid:87)(cid:85)(cid:72)(cid:72)(cid:87) (cid:54)(cid:88)(cid:76)(cid:87)(cid:72)(cid:3)(cid:41) (cid:54)(cid:72)(cid:84)(cid:88)(cid:76)(cid:80)(cid:15)(cid:3)(cid:58)(cid:36)(cid:3)(cid:28)(cid:27)(cid:22)(cid:27)(cid:21) Port Angeles (cid:20)(cid:20)(cid:19)(cid:3)(cid:49)(cid:17)(cid:3)(cid:36)(cid:79)(cid:71)(cid:72)(cid:85)(cid:3)(cid:54)(cid:87)(cid:85)(cid:72)(cid:72)(cid:87) (cid:51)(cid:82)(cid:85)(cid:87)(cid:3)(cid:36)(cid:81)(cid:74)(cid:72)(cid:79)(cid:72)(cid:86)(cid:15)(cid:3)(cid:58)(cid:36)(cid:3)(cid:3) (cid:28)(cid:27)(cid:22)(cid:25)(cid:21) Mountlake Terrace (cid:21)(cid:21)(cid:27)(cid:19)(cid:26)(cid:3)(cid:23)(cid:23)(cid:87)(cid:75)(cid:3)(cid:36)(cid:89)(cid:72)(cid:81)(cid:88)(cid:72)(cid:3)(cid:58)(cid:17) (cid:48)(cid:82)(cid:88)(cid:81)(cid:87)(cid:79)(cid:68)(cid:78)(cid:72)(cid:3)(cid:55)(cid:72)(cid:85)(cid:85)(cid:68)(cid:70)(cid:72)(cid:15)(cid:3)(cid:58)(cid:36)(cid:3)(cid:3) (cid:28)(cid:27)(cid:19)(cid:23)(cid:22) Tacoma (cid:21)(cid:28)(cid:23)(cid:20)(cid:3)(cid:54)(cid:17)(cid:3)(cid:22)(cid:27)(cid:87)(cid:75)(cid:3)(cid:54)(cid:87)(cid:85)(cid:72)(cid:72)(cid:87) (cid:55)(cid:68)(cid:70)(cid:82)(cid:80)(cid:68)(cid:15)(cid:3)(cid:58)(cid:36)(cid:3)(cid:3)(cid:28)(cid:27)(cid:23)(cid:19)(cid:28) University Place (cid:23)(cid:28)(cid:21)(cid:21)(cid:3)(cid:37)(cid:85)(cid:76)(cid:71)(cid:74)(cid:72)(cid:83)(cid:82)(cid:85)(cid:87)(cid:3)(cid:58)(cid:68)(cid:92)(cid:3)(cid:58)(cid:72)(cid:86)(cid:87) (cid:56)(cid:81)(cid:76)(cid:89)(cid:72)(cid:85)(cid:86)(cid:76)(cid:87)(cid:92)(cid:3)(cid:51)(cid:79)(cid:68)(cid:70)(cid:72)(cid:15)(cid:3)(cid:58)(cid:36)(cid:3)(cid:28)(cid:27)(cid:23)(cid:25)(cid:26) Port Ludlow (cid:28)(cid:24)(cid:19)(cid:19)(cid:3)(cid:50)(cid:68)(cid:78)(cid:3)(cid:37)(cid:68)(cid:92)(cid:3)(cid:53)(cid:82)(cid:68)(cid:71)(cid:15)(cid:3)(cid:54)(cid:87)(cid:72)(cid:17)(cid:3)(cid:36) (cid:51)(cid:82)(cid:85)(cid:87)(cid:3)(cid:47)(cid:88)(cid:71)(cid:79)(cid:82)(cid:90)(cid:15)(cid:3)(cid:58)(cid:36)(cid:3)(cid:28)(cid:27)(cid:22)(cid:25)(cid:24) 

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