The dozen or so banks caught up in an alleged land development fraud in western North Carolina may not recover much of the $100 million they have lost, but some are trying to make sure that they do not get fooled again.
The banks made hundreds of loans to consumers who used the money to buy lots in the Village of Penland development, a 1,200-acre project in Spruce Pine, N.C. Problem was, the developer, Peerless Development Group, never actually built the infrastructure, such as sewage and water lines, and in some cases even sold lots that were too small for houses.
The proceeds from lot sales were used instead to fund other projects — and expensive vacations for Peerless' executives — according to the North Carolina attorney general, who shut down the project in June.
Bankers say — and analysts agree — the fraud was so sophisticated that it was difficult to spot patterns early on. Still, the experience has led banks to change how they review real estate loans to individuals. Among the safeguards banks are adopting: assigning fewer underwriters to handle consumer lot loans in one state or region, upgrading software to detect unusual spikes in loans in a branch or region, and requiring top executives to sign off on predevelopment lot loans.
"It's forced the banks to take their procedural oversight to a much deeper level then they have in the past, at least in this area as it relates to lot lending," said Jeff K. Davis, an analyst at First Horizon National Corp.'s FTN Midwest Securities Corp.
Mr. Davis said that lax underwriting was not the problem. Instead, the developers "exploited a weakness" in the banks' credit procedures, which let many people borrow through the retail system but "escape the eyes of loan review because loan review is typically more focused on commercial real estate exposure."
The $14 billion-asset South Financial Group in Greenville, S.C., and the $8.2 billion-asset United Community Banks Inc. in Blairsville, Ga., were among the hardest-hit banking companies.
South Financial estimated that it had about $20 million of exposure to the Penland development and charged off about $10 million. United in December said it charged off $18 million.
Part of the problem was the extent of the alleged collusion.
"In this case you have a developer, a closing attorney, and an appraiser all involved in the alleged fraud," said Kevin Fitzsimmons, an analyst at Sandler O'Neill & Partners LP. "There's only so much you can do to detect that and prevent it."
Bankers and analysts also said that some individual borrowers might have been in on the scheme, too, perhaps with the intention of quickly flipping the properties.
The developer allegedly promised people that they would get a percentage of their investment in cash upon closing and encouraged them to buy more than one parcel, taking out loans from multiple banks, which made it harder for the banks to see the fraud pattern emerging.
Mr. Fitzsimmons said that, before the fraud came to light, banks viewed these lot loans as separate consumer credits, with the property as collateral.
"A lot of banks had no idea they had 70 or 80 loans tied to a single developer," he said.
Lynn Harton, South Financial's chief risk and credit officer, said that lot loans are generally made to borrowers looking to build homes in resort areas. Among the changes South Financial has made is to consolidate all lot loans in the hands of a smaller number of senior underwriters because, in the Penland scheme, loans would come in for scrutiny seemingly at random and to different underwriters at wide intervals.
"One underwriter is going to get all the lot loans for any subdivision in North Carolina," Mr. Harton said, "so you start to see patterns. A human can pick up a pattern. You can't program a computer to pick up everything."
Branch managers are also being required to do far more due diligence, he said, such as certifying that they have walked a property, making sure that improvements are in, and being aware whether the developer is "providing any unusual incentives."
Rex S. Schuette, United's chief financial officer, said in an interview Thursday that the bank put in a red-flag reporting system that highlights any irregular variances or spikes in loans and dollar amounts from previous months' performance at a branch.
"It's not just looking at total construction loans," he said. "We've now taken it down two or three notches to a lower level of refinement."
Another procedure United has adopted, Mr. Schuette said, requires that the bank's chief risk officer approve any loan for any predevelopment.
The North Carolina attorney general has filed a civil suit against the developer and others involved in the alleged scheme, demanding that they refund money to purchasers so that they can repay their bank loans.
No individual borrower has been charged in the scheme, though Mr. Schuette said that some must have known the developer was up to something because they did not notify United that they were getting cash back at closing or that they were also taking out loans with other banks.
The borrowers had good credit, but "if we were aware that they were borrowing from other banks, they wouldn't have qualified," he said.
"They knowingly signed three or four closing statements at one time, which has to tell you you're doing something that's not right."
Other banks involved in the development included BB&T Corp. in Winston-Salem, N.C.; Mountain 1st Bank and Trust Co. in Hendersonville, N.C.; and Bank of America Corp. and First Charter Corp., both in Charlotte.
BB&T and Bank of America declined to comment for this article, citing pending litigation related to the project, and Mountain 1st did not return telephone calls.
First Charter, which placed $5.4 million of Penland lot loans on nonaccrual status in the second quarter, also declined to comment but said in a Securities and Exchange Commission filing in August that it has adopted procedures designed to mitigate risk. Now, when someone applies for a lot loan, it requires its lenders to collect information on the developer and subdivision. It also restricts consumer loan originations to borrowers from the bank's primary markets.
