When the derivatives plague visited Kentucky's Pikeville National Corp., it caught an otherwise farsighted management team unawares.

"We realized the problem in the first week of October," said Terry N. Coleman, president and chief operating officer of Pikeville National in Pikeville, Ky. "In reviewing them [derivatives investments], it was clear they were too volatile. They never should have been put in the trust account to begin with."

The $1.38 billion bank in the third quarter suffered a $1.8 million after-tax loss on mortgagebacked securities, a form of derivative. The bank bought the investments for its trust customers, and absorbed their loss.

The hit, coupled with $945,000 in restructuring costs, resulted in a 94% drop in net income for the quarter ending Sept. 30, compared with the same quarter last year.

The securities were purchased by the bank's trust company, which was formed in January of 1993. Mr. Coleman added the bank has had "some changes in management at the trust company and changes in procedures" since the revelations.

The trust account customers will be protected because the bank is absorbing the loss by offering to purchase the securities from the holders, Mr. Coleman said. The securities, first bought sometime in 1993, make up less than 1% of the trust company's total assets and have an estimated total face value in the $5 million range, he said.

Pikeville National will hold on to the vast majority of the securities until maturity, believing they eventually will recover the full face value. Mr. Coleman estimated the loss in the end will be "substantially less" than the onetime charge the bank took in the third quarter.

Pikeville National is not the first and certainly will not be the last financial institution to see its bottom line nose-dive from investments in derivatives. Already this year several banks and financial advisors have been hit with lawsuits from investors, claiming they had no idea what they were getting into.

"This will be a rather common problem I believe," Mr. Coleman said. "Several banks have done the same thing, and I think more will become aware of it when they look into their trust investments. This will not be unusual."

Many of these investments, such as Pikeville National's, are tied to market indexes like interest rates.

One of Pikeville National' s investments, for example, involved an instrument called an inverse floater, the value of which moves in the opposite direction as interest rates. The Federal Reserve's boosting of rates this year has therefore greatly lowered the value of such securities, rendering them illiquid.

Pikeville National has weathered the loss well, said Alan Motel, vice president of Hilllard & Lyons, a bank consulting and brokerage firm in Louisville.

Pikeville's stock was trading as high as $34 earlier in the year, dropped to $21.50 when the third quarter report came out and is now back up to $27.50. The current market price is about two times book value, he said.

"They've bounced back already," he said. "It should be back close to normal in the fourth quarter, with the costs spread out over the first two quarters of 1995."

While Mr. Morel and other analysts described Pikeville National as a strong institution with quarterly earnings normally in the $2 million to $3 million range, the bank has had some subpar quarters in 1994.

Besides the thirdsquarter setbacks, the second quarter reflected a 58% decrease in net income from the same quarter last year. The decline was due primarily to the unexpected chargeoff of two loans totaling $1.6 million, according to the quarterly statement.

In the first quarter of the year, net income declined 17% from the first quarter of 1993, due to a fall in the net interest margin. Higher noninterest expenses and a decline in fees from mortgage originations also contributed to the fall, the report read.

Despite the poor numbers, Mr. Morel, who visited with the bank officials last week, said PikeviHe National should be poised to reach its full potential, which the bank believes is 15% earnings growth per year. This will be achieved in part by the restructuring program that cost the bank nearly $1 million in the third quarter.

Part of this amount covered severance pay for the 55 employees the bank plans to let go as part of its streamlining process. It has also recently installed an automation system with enough capacity to allow the bank to grow to a $10 billion institution, Mr. Motel said.

Pikeville National signed letters of intent to acquire three institutions in the third quarter, which will boost its assets to about $1.75 billion, making it one of the largest bank holding companies in the state.

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