Fannie's House of Cards

I received an email today from a real estate appraiser commenting on my article about the possible fraud in Fannie Mae's (NYSE:FNM) numbers. The reader's point was that the $10 billion or so uncovered thus far is just the tip of the iceberg and the real estate house of cards will be blown over when the true magnitude of the overvalued assets in Fannie's portfolio comes to light.

Initially, I thought it was going to be the typical "crank" letter I receive when someone thinks I'm trash-talkin' a stock they own. You write an article saying that aesthetic laser-maker Candela (NASDAQ:CLZR) has been better at making promises than increasing shareholder value, and you're immediately accused of being short the stock. Note that Inter Parfums (NASDAQ:IPAR) had the potential for lower sales and thus lower earnings, and you're a shill for the competition. The litany of abuses ascribed to Fool writers is endless.

But the point of this email rang true: Fannie's portfolio is vastly overvalued because appraisers routinely overstate the market value of a house by 5%, 10%, 20%, or even more. A portfolio of houses worth less than their appraised values could affect Fannie Mae's ability to sell securities backed by mortgages on those houses. If it's unable to sell its securitized mortgages, the vast real-estate machinery would grind to a halt as the funds juicing the market slow, bringing down the house of cards. Sadly, I think he's right.

Nevertheless, as I thought about what he wrote, I realized it's not just Fannie Mae and Freddie Mac (NYSE:FRE) that have a problem with overvalued homes. It's a shared predicament for all lending institutions. What's the exposure of a money center like Citigroup (NYSE:C) or even a regional bank like Fulton Financial (NASDAQ:FULT)?

Think about when you wanted to buy your house or refinance your mortgage. To make sure you qualified for the loan you wanted, the house appraised for the highest value and an obliging appraiser marked it up. Now before I start getting angry emails from appraisers, I am well aware that there are good and honest appraisers who don't get involved in such skullduggery. But there's a whole mortgage-lending industry that all too easily allows itself to be fooled so that it can loan out the money. However, it's hard to believe that the froth building up in housing can withstand reality for much longer.

Though I've been a homeowner in the past (and, no, I never engaged in the practices mentioned above), I currently rent precisely because I refuse to overpay for housing. In my area, a two-bedroom, one-bath bungalow on a postage-stamp-size lot starts at $350,000. I'm told to buy because the next person to come along after me will scoop it up and reap the benefits of appreciation.

Well, these spiraling prices can only go on for so long. The era of cheap money can't last forever. And my email writer is right: "When the markets finally get wise and decide to put their money someplace besides these institutions' products, the torrent of cheap mortgage money will slow to a trickle of very expensive mortgage money, and then Katie, bar the door!"

It might not start today or tomorrow or even next year. But the trickle will turn to a flood and the torrent will wipe out many, and we'll only have ourselves to blame. Years ago, the comic strip Pogo summed it up best: "We have seen the enemy and they is us."

Build up a base of knowledge with these Foolish links:

• Feds Find Fraud at Fannie?
• What Housing Bubble?
• Interest in Interest-Only?
• Beware of "Extreme" Mortgages
• Motley Fool Home Center

Fannie Mae is a recommendation of Motley Fool Inside Value .

Fool contributor RichDuprey is a devotee of Calvin and Hobbes and owns shares in Fannie Mae and Candela. He does not own any of the other stocks mentioned in this article. The Motley Fool has a disclosure policy.