Fraud Identification Training Sept-Oct 2022

CASE STUDY 11

THE CASE OF “THE FLIP SIDE”

Situation:

You are the Asset Manager (AM) for an institution that has nearly doubled in size since the previous examination. The bank has historically been a 1- to 4-family residential lender. However, growth since the previous examination centers in acquisition, development, and construction (ADC) lending. Funding for loan growth is primarily derived from high-cost brokered certificates of deposit (CD). The institution’s growth and funding strategy are apparently the byproducts of a booming regional economy and real estate market. Significant management changes have contributed to the bank’s expansion into ADC lending. The bank’s new Chairman of the Board (COB) and majority shareholder, Bart Smite, has been particularly instrumental in affecting the bank’s changing profile. In fact, COB Smite has brought in a lot of very profitable business through his land development firm (Python Holdings, Ltd.) and various business acquaintances. The former senior vice president (SVP) of lending, Wayne Flaggall, resigned. According to President Guy Lamb, COB Smite convinced the Board that Mr. Flaggall did not have sufficient expertise in ADC lending, and some “new blood” was necessary to fill the void. As a result, the bank hired SVP Raymond Gladda to spearhead the bank’s venture into ADC lending. You review one of the bank’s largest ADC credits, which is an extension of credit to Python Holdings, Ltd. in the amount of $5.2 million. The file indicates that the property is to be developed into condominiums, with development financing to come from outside sources. The loan terms are interest only at prime plus 2% for a term of one year. The title documents indicate that the loan is secured by a first lien deed of trust on 32.64 acres of undeveloped land. Although there is no formal guaranty, SVP Gladda indicated that there was an “unofficial” guarantee from COB Smite. Nearly $4.3 million was disbursed at closing. A majority of the remaining funds was marked for interest carry. The file contains a three page “letter appraisal” addressed to Python Holdings, Ltd. and prepared by D. Crabaugh & Associates. The letter indicates that the cumulative retail market value of the property, if subdivided into six condominium tracts, and if roads were developed as planned, is $8.1 million. The appraisal does not include an income approach or a cost approach. However, the appraisal does include a sales approach. You note that the sales comparables are out-of-territory, and the appraiser made some hefty adjustments for view, location, and size. The appraisal indicates that the highest and best use is “developed for retail office space,” but there are no sequential tests for legally permissible, physically possible, or economically feasible. The appraisal does not include the required sales history for the property. A review of the settlement

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