Two Midwest community banks have taken sizable charges because of securities investment losses.

Princeton National Bancorp in Illinois is charging off $2.8 million for mortgage derivatives, which resulted in about a $2 million loss in the first quarter, the company said. The move should pave the way for a more profitable 1996, the company said.

Meantime, PSB Holdings Corp., Xenia, Ohio, is taking a $4.5 million charge, including $3.9 million related to the sale of securities as part of a house cleaning before it merges with Dayton, Ohio-based Citfed Bancorp. The company declined to estimate first-quarter earnings.

The problems at Princeton National and PSB Holdings highlight the fact that community banks are as susceptible to securities losses as larger institutions.

Princeton's bank subsidiary, Citizens First National Bank, ran into trouble in customer trust accounts by using hedging derivatives called "inverse floaters," which decreased in value when interest rates rose.

"We decided it was in everybody's best interest to go ahead and liquidate them," said D.E. Van Ordstrand, president and chief executive officer.

Inverse floaters are mortgage-backed bonds, usually part of a collateralized mortgage obligation, that move in the opposite direction from an index such as the London interbank offered rate.

Nearly all the inverse floaters in Citizens First's customer trust accounts were liquidated during the first quarter, Mr. Van Ordstrand said.

Princeton will absorb the losses through its after-tax charge; it remains well-capitalized, does not anticipate effects on dividends during 1995, and expects earnings improvement in 1996.

The charge, however, caused Gregory P. Anderson, an analyst at Chicago Corp., to reduce his 1995 earnings-per-share estimate for the $390 million- asset bank holding company by 71%, to 42 cents. In 1994, the company earned $1.39 per share, compared with $1.38 in 1993.

"I think it's going to take this year to put this behind them," Mr. Anderson said. "It wipes out three quarters of earnings."

Mr. Anderson said smaller banks typically don't have the sophisticated risk-management systems necessary to deal with hedges like inverse floaters.

"I was a little bit taken aback" to learn Citizens First had such investments, he said. "It's not something I typically ask a company: 'Do you use inverse floaters in your trust accounts?' "

But he said the hit is not "fatal."

"It's a nice franchise," he said. "It just needs some fine-tuning, and an issue like this doesn't help."

Mr. Anderson maintains a "hold" rating on Princeton's stock because of concerns about loan growth and a 27-basis-point margin contraction in 1994.

Going forward, the bank has reorganized its trust department and changed its investment philosophy.

"We don't intend to use inverse floaters in the future," said Mr. Van Ordstrand.

The bank is exploring a variety of alternatives, including investing funds in three-year to seven-year government securities, he said.

The senior investment officer responsible for investing in inverse floaters has left the company, but Mr. Van Ordstrand said fallout from the investments was not the only reason for the departure.

In Ohio, PSB Holdings, the parent of Peoples Savings Bank, was stung when it sold its $63 million portfolio of securities at a $3.9 million loss in preparation for the merger.

"We just wanted it squeaky clean," said Citfed president Jerry L. Kirby, whose $2 billion-asset company announced last month its definitive agreement to acquire PSB.

Mr. Kirby said the problem at the $178 million-asset Peoples Savings was identified during due diligence.

The merger, which is expected to close this fall after regulatory and shareholder approvals, was a catalyst for the securities liquidation, said Kent Martin, PSB's executive vice president.

"We probably would've done some of them anyway," he said, perhaps over the year instead of immediately.

PSB had $4.7 million set aside for unrealized losses and other equity adjustments at yearend, Mr. Martin said.

The company said it will continue to exceed regulatory capital requirements after the charge, which also included $213,000 from an increase in the loan-loss reserve and $700,000 for merger-related fees.

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