Cover Story November 5, 2009, 5:00PM EST

Why This Real Estate Bust Is Different

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In court proceedings, a Bluegreen employee said the signatures on the documents weren't his. Another supposed tenant, Mia Group, said in court filings that the lease on file for the restaurant company was invalid because it was signed by a business associate who didn't have authority to do so. "He was a few leases short of what he needed to get the loan," says Andrew F. Spalding, a Houston attorney who is representing Prudential. "I'm sure his thinking was just like that of most other developers: Even if the tenants were fake, he figured he could still fill that space in no time with someone else."

An attorney for Faidi, Robert A. Axelrad, says the disputed lease for Bluegreen was arranged by an outside broker. He acknowledges that the loan application included future rent payments from Bluegreen, but he says the figures were meant to be "pro forma" estimates based on the possibility of Bluegreen occupying the space. "My client says he never saw the lease and never represented there was a lease," says Axelrad. Faidi filed for personal bankruptcy in September. The civil case is ongoing.

Glaring problems that normally would have raised red flags seemed to be in plain sight of loan officers during the credit boom. Phoenix entrepreneur John J. Wanek appeared to have the right credentials when he applied for a $6.5 million loan from Merrill Lynch to buy the Ashberry Village Apartments in 2002. The sprawling ranch-style complex in Columbus, Ohio, would be the latest addition to his small, Midwestern real estate empire. He had never missed a payment on a half-dozen similar properties. And the rent rolls Wanek provided showed that more than 90% of Ashberry's units were occupied. After Wanek defaulted within six months, Merrill concluded that it had been duped. It claimed in a civil suit filed in a Franklin County (Ohio) court that Wanek had altered the rent-roll numbers to make the complex look more profitable. Merrill, which is now owned by Bank of America (BAC), contends that the complex was nearly one-third vacant at the time, and that Wanek had "grossly understated" the operating expenses. According to the suit, Wanek had inflated the numbers to get a bigger-than-necessary loan and used the extra money to cover back payments on other apartment buildings.

Even if the allegations are true, Merrill should have seen the warning signs. According to the suit, after applying for the loan, Wanek told Merrill he would transcribe data from the previous owner's supposedly illegible rent rolls into easier-to-read spreadsheets. In the process, he boosted many figures to suspiciously round numbers. Wanek also overstated his equity in the real estate he posted as collateral and listed some of his parents' assets as his own.

An attorney for Wanek, Mark C. Collins, says his client recreated the rent rolls—with Merrill's approval—only because his office had been burglarized and many records stolen 10 days before closing. "He prepared those numbers as best he could off the top of his memory," says Collins. "The proper due diligence wasn't done by anyone, but they want to make the buyer the scapegoat." Wanek, who filed for bankruptcy shortly before he lost the civil case in January 2006, now faces criminal fraud charges from the Franklin County prosecutor.

All told, Merrill and the lenders on Wanek's other properties have lost $38 million. His parents, two retired schoolteachers, had to file for bankruptcy as well. "Lenders were willing to underwrite on his record and the revenue stream of the property," says David D. Ferguson, an attorney who represented Merrill. "But it was a scheme doomed for failure."

With John Cady in New York

Der Hovanesian is Banking editor for BusinessWeek in New York. Foust is chief of BusinessWeek's Atlanta bureau.