After what may be the largest case of loan fraud in its history, the Department of Agriculture is facing criticism from the investment firm that got burned.

Meanwhile, the agency may also be contemplating reforms designed to prevent a repeat.

Pennant Management, a Milwaukee investment firm, has said it invested $179 million, on behalf of clients, in securities backed by what turned out to be bogus USDA-guaranteed loans. Rebuffed by the USDA in its efforts to obtain payment, Pennant has appealed the agency's decision and is considering other options if it is denied again.

"We still feel that this is a full-faith-and-credit obligation, so we will continue to pursue the Department of Agriculture," said Mark Elste, Pennant's chief executive. "We have the best wishes of our clients in mind."

Pennant's major complaint is that, unlike other government-backed loan programs, the USDA's programs have no central transfer agent or database to allow buyers to easily confirm that they're buying legitimate guaranteed loans.

Some buyers have pushed for such a system for years. As far back as 2010, for instance, at a roundtable discussion with industry participants, the USDA administrator of the program was urged to "consider establishing a fiscal transfer agent for standardized secondary market activity and statistical data gathering mechanism," according to a summary of the discussion.

Instead, buyers need to contact the state USDA office through which each loan was originated to verify that what they are buying is legitimate.

And even that doesn't always work, Pennant contends. When the investment firm became suspicious that it was holding fake loans, it asked the USDA to verify the loans over the phone.

The agency refused, Elste said. He also claims that it took a written request from Pennant's lawyer before the USDA disclosed that it had no records of the loans. "You have to put a request in writing to get any response, and that really doesn't facilitate an active secondary market," he said.

While it appears unusual — if not negligent — of Pennant to buy so many loans without verifying them directly with the USDA, other buyers said that verifying loans before purchase was not the standard procedure in the secondary market.

For instance, Greg O'Donnell of the National Rural Lenders Association, a recently formed trade group for the USDA loan market, said that, before news of this allege fraud broke, most buyers he knew did not verify their loans directly with the USDA.

"Most did not do it before, because we never had this problem before," O'Donnell said.

The USDA did not immediately respond to a request for comment on Pennant's claims or its possible reform efforts.

Shortly after news of the alleged fraud broke, the agency said last month that it has asked its regional offices to immediately respond to all requests to verify loans. Buyers say the agency has promptly responded to all requests for verification.

That quick response has helped calm the secondary market for USDA loans after news of Pennant's sham loans broke. In a lawsuit filed in late September, Pennant said it bought 26 fake loans from First Farmers Financial, a Florida firm that had been approved by the USDA to originate business-and industrial-loans through the agency's rural-development program.

Nikesh Patel, First Farmer's founder, allegedly forged the signatures of USDA officials to pass the fake loans off to Pennant. He was arrested last month, but the Federal Bureau of Investigation is still assessing the scope of the alleged crime and has not yet indicted him.

The good news is that, for now, no other fake loans have surfaced, buyers said, and the loans Patel sold to other companies appear to be legitimate. The secondary market has returned to normal both in volume and pricing after freezing up right after the scandal broke.

"I won't say it is business as usual, but it's pretty darn close," said Brian Folk, president of Coastal Securities. "We think this [fraud] was not widespread at all, just one bad apple. We have dealt in these loans long enough, and we hold positions long enough, that if this was widespread we would have found out."

Other players in the secondary market said that the difficulty Pennant claims to have had verifying its loans is unusual. But they do echo Pennant's complaints about the fractured and opaque secondary market.

"It may simply be that lighting struck and this will never happen again," said D. Ann Komar, Coastal Securities' executive vice president of sales and trading. "But the fact that lightning struck would almost by definition reveal a flaw in the documentation process."

Though it appears to be an isolated and contained case of fraud, efforts are under way to make sure it's not replicated. Almost all buyers have tightened their screening procedures, and industry players said they have had discussions with the USDA about making the secondary market more secure.

So far, the changes mostly involve internal controls. Coastal Securities, for instance, has reviewed all its loans and will not trade a loan until it has been verified with the USDA.

While O'Donnell doesn't think the USDA did anything wrong in this case, his group has asked the agency not to issue any more guaranteed-lender licenses to nonbank lenders like Patel. He also wants to push the USDA to administer the program more consistently across all its state offices.

Other suggestions for reform differ widely. Folk thinks the agency should create a database of loans where buyers can log in and confirm that the guarantee they're buying is legitimate. Vasu Srinivasan, president of Thomas USAF, recommended tweaking the sales process so that a loan won't be certified as sold without proof that the USDA has been paid its guarantee fee.

In general, Srinivasan said he thinks the protocols in place need a few tweaks rather than a wholesale reform, adding that the main cause of the fraud was Pennant's failure to follow the protocols. He also thinks calls for a fiscal transfer agent like in the SBA 7(a) program are misguided, given the small size of the USDA loan program.

"A fiscal transfer agent for a program this small is very expensive. A transfer agent would create a bureaucracy at a considerable cost, and all for the stupidity of one guy," he said.

Pennant's Elste favors requiring a medallion signature-guarantee stamp, verified by a third party, on the loan documents.

O'Donnell, however, said he doubts that improving the paperwork will help, since someone determined to commit fraud can forge just about any document. Rather, he said loan buyers and the USDA should just make it a uniform policy to verify all loans over the phone.

"The easiest solution is just for the secondary-market buyer to pick up the phone, call the state offices and confirm the guarantee," O'Donnell said. "We've talked with some of the state offices and they don't have a problem with it. But if you go to a transfer agent, all it does is add cost to everybody."

As the industry contemplates reform, speculation abounds over which investors will take losses in the alleged fraud. Many community banks invested in Patel's loans through Pennant, and those institutions could suffer serious cash shortfalls as a result.

So far, two banks have confirmed that they face losses over the alleged fraud: Harvard Illinois Bancorp, which said it expects to lose $8.5 million of the $18.1 million it invested, and Blackhawk Bancorp in Beloit, Wis. Blackhawk recorded a $2.6 million charge in the third quarter due to the alleged fraud; the $600 million-asset company invested $5.5 million in the fake securities.

Harvard Illinois said Monday that it had hired an investment bank to explore "strategic alternatives," which could include a capital raise or, possibly, a sale.

The relatively high recoveries Blackhawk and Harvard Illinois expect seem to indicate that efforts to liquidate Patel's assets to pay off the sham loans are going well. Patel has been "cooperative," Elste said, and has agreed to sell his assets — including five hotels, two homes, four cars, including a Lamborghini and a Rolls Royce, and several luxury watches — to repay Pennant's losses. The court appointed a receiver this month to handle the asset sales and distribution to Pennant.

The other two victims of the alleged fraud that have been identified are the Illinois Metropolitan Investment Fund, which had about $50.4 million invested through Pennant, and the retirement fund for the American Excelsior Company, a Texas manufacturer, which invested $13.6 million shortly before news of the alleged fraud broke. The retirement fund sued Pennant last month in a Texas district court, claiming that the investment firm failed to disclose its suspicions about the loans.

Most industry participants think Pennant's best chance to make their clients whole is by targeting Patel's assets. Nearly all of them doubt the USDA will be persuaded to pay out the guarantee on what were not in fact guaranteed loans.

"If you buy a counterfeit $100 bill, you don't get to sue the Treasury Department for $100," Srinivasan said.

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