New York Expands Its Probe
Into Fannie Mae and Freddie Mac

A widening investigation of inflated home appraisals and a gloomy forecast by Washington Mutual Inc. knocked shares of mortgage companies lower.

Freddie Mac and Fannie Mae, prodded by New York State Attorney General Andrew Cuomo, agreed to appoint independent examiners to look at whether they have done enough to protect mortgage investors from the risks of inflated home appraisals, particularly on loans from WaMu.

Separately, at an investor conference in New York, WaMu said the outlook for the mortgage industry next year is even bleaker than many in the industry believe. The bank predicted total U.S. mortgage originations will drop from about $2.4 trillion this year to $1.5 trillion in 2008, well below industry forecasts of about $1.9 trillion to $2 trillion for next year.

As part of a nine-month probe of the mortgage business, Mr. Cuomo sent letters and subpoenas Tuesday to Fannie and Freddie, government-sponsored companies that acquire mortgage loans from lenders and package many of them into securities for sale to investors.

"The subject of the investigation is what they knew, when they knew it and what they did about it," he said in an interview. He said his staff continues to study problems in the mortgage industry, including the role of investment banks, which also create mortgage-backed securities for sale to investors.

Shares of Fannie fell $5.60, or 10%, to $49.79, while Freddie shed $4.26, or 8.6%, to $45.13, both in 4 p.m. New York Stock Exchange composite trading.

WaMu shares tumbled $4.19, or 17%, to $20.04, also on the Big Board. The shares are down 56% this year and at their lowest point in more than seven years. WaMu, the country's biggest savings and loan, was the sixth-largest U.S. home mortgage lender in this year's first nine months in terms of loan volume, according to trade publication Inside Mortgage Finance.

"We just don't know when the housing market is going to improve," Kerry Killinger, WaMu's chairman and chief executive, said at the investor conference, though he argued the bank's long-term outlook remains strong. Yesterday, an analyst at Lehman Brothers cut his 2008 earnings estimate for the bank by 30%, to $2.24 a share from $3.20, based on his expectation of higher credit losses.

In his letters to Fannie and Freddie, Mr. Cuomo wrote that inflated appraisals, giving a false idea of the value of collateral backing those loans and securities, could hurt shareholders of those companies and investors in mortgage-backed securities they guarantee. Many appraisers have complained for years they feel pressure from lenders and mortgage brokers to sign off on unrealistically high home-value estimates.

Mr. Cuomo directed Fannie and Freddie to appoint examiners to look particularly at mortgages acquired from WaMu and any other loans made on the basis of appraisals by First American Corp.'s eAppraiseIT LLC subsidiary. Last week, his office filed a lawsuit against First American, alleging it violated federal and state laws by allowing WaMu to control the selection of appraisers hired to assess collateral for loans.

First American said last week the suit "has no foundation in fact or law."

WaMu issued a statement yesterday, saying the bank "takes any allegations of improper practices seriously, and is continuing its investigation into this matter." Further, WaMu said it will continue to ensure its operations comply with all applicable laws. WaMu also said both Freddie and Fannie have confirmed they are continuing to purchase loans from WaMu "in accordance with their existing contracts."

Mr. Cuomo's staff isn't looking only at WaMu loans. "Pressure on appraisers and inflated appraisals appear to be widespread problems in the mortgage industry," he wrote in the letters to Fannie and Freddie.

Fannie and Freddie both said they will cooperate with the investigation.

Email your comments to bob.hagerty@wsj.com.