A Florida real estate developer may have found a weakness in the market for government-backed loans and, in the process, punched a gaping hole in many community banks' bottom lines.
Companies that invest in loans backed by the U.S. Department of Agriculture have been scrambling to assess the damage after it was revealed late last month that a large number of purportedly agency-backed loans may be fake. Nikesh Patel, a prominent Orlando investor and a USDA-approved loan originator, was arrested Sept. 30 for allegedly selling up to $179 million in sham government-insured loans.
The finger-pointing has already begun, with some blaming poor due diligence by the buyer of Patel's loans and others arguing that a lightly regulated secondary market opened the door to the alleged scam. Unlike other secondary markets for government-backed loans, there is no central transfer agent for the loans Patel claimed to be selling, an absence that some investors have long complained about.
Ultimately, community banks that invest in the USDA-backed loan market could end up holding the bag. Lawyers expect a torrent of lawsuits related to the alleged fraud.
"There was a breakdown in the system for everybody who touched the loan," said Bob Coleman, who analyzes the government-backed loan market for banking clients.
Patel's company, First Farmers Financial, was one of a handful of so-called nontraditional lenders approved by the USDA to originate business and industrial loans backed by the agency's guarantee program. This program insures certain commercial loans of up to $10 million that benefit the economy of rural areas.
A Federal Bureau of Investigation affidavit claims that Patel "fabricated loan-guarantee forms" by forging the signatures of government officials and inventing borrowers. He then sold the guaranteed portion of the fake loans, the FBI alleges.
The company that bought them, Pennant Management, filed a lawsuit against Patel in a federal court in Illinois the day of his arrest, claiming that it holds $179 million of loans from First Farmers. Small banks and other clients invest in Pennant to buy and manage loan portfolios on their behalf.
Some of the $179 million of loans may be real, but least three loans totaling $22.8 million are confirmed to be fraudulent, Pennant's complaint said.
If the accusations hold up, it will be by far the largest fraud involving the USDA's loan-guarantee program. The questionable loans held by Pennant represent nearly a quarter of the $800 million to $1 billion in annual originations in the USDA's business-and-industrial-loan program.
Worse still, the alleged fraud could be larger than $179 million. Other companies bought loans from Patel, investors say. The secondary market for USDA loans has seized up following the allegations, they say.
Many small community banks, particularly ones in Illinois, invest excess cash with Pennant, which offers better rates than Treasury bills by investing in paper that - in theory - is fully backed by the U.S. government. Pennant manages $850 million in guaranteed loans, the lawsuit said.
Harvard Illinois Bancorp is the only lender to disclose that it faces losses from investing through Pennant, and the consequences could be dire. The $171 million-asset company said its losses could hit $18.1 million, which would all but wipe out its $19 million in equity capital. Harvard Illinois' stock has fallen more than 65% since the possible fraud was announced.
Representatives of Harvard Illinois did not respond to a call seeking comment.
There will be plenty of blame to pass around for Harvard and the other community banks that invested with Pennant, industry observers said.
For more than a year, Pennant failed to take basic steps that could have uncovered the fake loans, such as Googling the names of the borrowers, court documents suggest.
Pennant said in its complaint that it began funding loans made by Patel in June 2013 and did not notice anything wrong until last month, when a "routine review" revealed that the borrower did not exist. Banks that lost money will no doubt ask why this routine review was not performed earlier.
Industry observers also note that the alleged fraudster exploited a key vulnerability in the secondary market for USDA loans: the lack of a central intermediary between loan buyers and sellers.
Unlike the Small Business Administration guarantee program, where loans are sold and payments made through a transfer agent, buyers and sellers deal with one another directly in the secondary market for USDA loans. As a result, buyers are responsible for checking the paperwork and verifying the loans themselves.
With SBA programs, in contrast, loan sales and interest payments are made through Colson Services, the transfer agent, which also keeps a database of the loans.
"This may not have been impossible with a fiscal transfer agent, but it would have been a heck of a lot harder to pull off," said Ethan Smith, a lawyer at Starfield & Smith who specializes in government-backed loan programs.
A USDA spokeswoman said the agency has referred the allegations to its inspector general, and that it has revoked Patel's authority to originate agency-backed loans. The agency is also encouraging investors concerned about the authenticity of their loans to contact the state USDA offices where the loans originated.
"State offices have been instructed to immediately act upon any such request from a holder to provide them with assurance that the guaranteed loans they hold are valid," the agency spokeswoman wrote in an email.
A representative of U.S. Fiduciary Services, the parent company of Pennant Management, declined to comment.
The details of the alleged fraud as described in Pennant's lawsuit are complex, involving repurchase transactions that were never completed and funds shifted between various companies Patel controlled.
But the core of the alleged scam was remarkably simple and low-tech, requiring little more than a pen and a black-and-white printer. Patel allegedly made up fake borrowers, prepared fake loan documents with forged signatures of USDA officials, then sent the documents to Pennant's custodian, U.S. Bank, according to the lawsuit. Pennant then wired the money.
Patel paid the monthly interest and principal himself, making it appear as though the sham loans were performing, the lawsuit claims. Among Patel's investments with the proceeds of the loans, according to the lawsuit, were a $4 million house in a wealthy Orlando suburb and a chain of Bennigan's restaurants he planned to open in India.
Patel's lawyer, Mark NeJame, did not return a phone call seeking comment. Patel was released on bail, and the government has frozen his assets.
The alleged fraud appears to stem from due-diligence failure rather than a fundamental flaw in the USDA program, says Vasu Srinivasan, president of Thomas USAF Group, which is one of the largest buyers of USDA loans.
Thomas USAF's protocol involves multiple levels of verification before buying a loan, including confirmation with the USDA, Srinivasan said. By sticking to this system, Thomas USAF was not touched by this fraud and has never had a problem with fake loans, he said.
The huge volume of loans Patel claimed to be able to originate should have been a warning sign, Srinivasan said. "Banks, even those that are very active, don't originate that much volume, because of the intricacies of the program," he said.
The unprecedented scale of the alleged fraud perhaps makes it more understandable that Pennant let its guard down.
"In fairness to [Pennant], you don't expect to be dealing with fraudsters," Srinivasan said. "In 30 years, this is the first incident like this that I can recall."
Pennant, in its lawsuit, sought to lay some of the blame on the USDA, stating that it "relied on the fact that [First Farmers Financial] had undergone a supposedly rigorous vetting process by both the state and national USDA offices."
The USDA said that no loans it has guaranteed are involved in the case, and legal experts said that attempting to get the agency to pay out for nonexistent loans is a dubious route to recovery. Still, community banks that lost money in the fraud may eventually recover some of their losses, if they can survive the initial shock to their capital levels.
Patel may have significant assets that can be recovered through litigation. He is a prominent investor in the hospitality industry, as well as a large political donor. In April, he held a fundraiser in his home for Rick Scott, the Republican governor of Florida.
And the court-ordered liquidation of his property has already begun. A Miami real estate company said Tuesday that it would buy five hotels Patel owns, with the proceeds going to Pennant. The terms of the agreement were not disclosed.
An Illinois district judge has also filed an injunction against Patel's real estate holdings and his personal property, including a Lamborghini, a Rolls Royce and miscellaneous watches and jewelry.
Before becoming a real estate developer, Patel worked for Comerica, Fifth Third and Beach Business Bank in roles connected to government-insured lending, according to biographical information available online and news reports. This past June, he applied to form a credit union in Orlando, but withdrew the application two months later.
As industry participants try to figure out the scope of the alleged fraud, questions remain about whether the USDA will make changes to prevent something similar occurring in the future.
"This will not be replicated," Coleman said. "I'm sure the adults in the room at USDA will institute some kind of system to verify that there is indeed a loan in place."
Adding a transfer agent like the one used by the SBA may not be the answer, Srinivasan said. Without an agent, a buyer of a loan can deal directly with the borrower if it is necessary to renegotiate the loan, which can deliver a better outcome for buyers. Transfer agents also charge fees.
Another possible reform would be to require electronic signatures on loan documents, which would make it more difficult to forge the loan guarantees. This is the favored approach of Patrick Kerrigan, director of business development for Farmer Mac, which is the largest buyer of USDA loans and holds a $1.7 billion portfolio.
Whether there will be comprehensive reform - or if reform is even necessary - will likely be determined in coming months. Nothing like this has happened before in the USDA program, and no one knows how the market or the agency will respond.
"I think [Patel] just noticed a hole in the process and found a way to exploit it," Smith said. "Who would think that a guy would just fabricate loans and get away with it for as long as he did? It makes you shake your head."