May 27 (Bloomberg) -- Fannie Mae and Freddie Mac's agreement to restrict banks from using in-house appraisal companies may violate federal law, U.S. Comptroller of the Currency John C. Dugan said in a letter to the companies' supervisor.

The two companies, which own or guarantee about 45 percent of the $12 trillion in U.S. home loans, made a deal in March with New York Attorney General Andrew Cuomo and the Office of Federal Housing Enterprise Oversight to stop buying mortgages from lenders that use in-house home appraisals for their loans.

The agreement and new appraisal code ``violate or conflict with federal law in fundamental respects'' and should be withdrawn, Dugan said in a letter to Ofheo Director James Lockhart. The Office of the Comptroller of the Currency, which regulates national banks, has ``substantial concerns about the unintended adverse consequences'' on U.S. banks, he said.

The OCC is joining mortgage and appraisal industry groups and the Office of Thrift Supervision in criticizing the deal, intended by Cuomo and Ofheo to make home valuations more accurate by separating them from the lenders making the loans. Reworking the agreement could make it harder for Fannie Mae and Freddie Mac management to address other investor concerns such as the $7.1 billion in cumulative losses Fannie Mae has posted over the last three quarters, analysts said.

Unneeded Distraction

``It's a distraction they don't need,'' said Jim Vogel, a debt analyst with FTN Financial Capital Markets, a division of First Tennessee Bank N.A. in Memphis, Tennessee. ``If this heats up the way the OCC seems to think it should, then you're going to throw sand in the gears of a number of other initiatives that are probably more important for today,'' he said.

Fannie Mae fell $1.06, or 3.8 percent, to $26.53 in composite trading on the New York Stock Exchange today. The stock has fallen 34 percent his year. Freddie Mac fell $1, or 3.9 percent, to $24.73, down 27 percent for the year. The companies had the two worst percentage drops on the S&P 500 Index today.

The ``appraisal process for home loans is broken,'' Cuomo's office said in an e-mailed statement. Cuomo began a probe of the U.S. mortgage industry last year as foreclosures among subprime borrowers climbed to a five-year high. The agreement with Fannie Mae and Freddie Mac is ``groundbreaking'' and will ``help consumers and restore integrity to this crucial market,'' the statement said.

Dugan's concerns are being taken into consideration, according to Ofheo spokeswoman Stefanie Mullin and the statement from Cuomo's office.

Unintended Consequences

Ofheo forwarded Dugan's letter to the companies and expects Fannie Mae and Freddie Mac to ``review this letter and the many other comments they received and to propose changes to the code to address unintended consequences,'' Mullin said in an e-mail.

Fannie Mae spokeswoman Janis Smith and Freddie Mac spokesman Doug Duvall both declined to comment.

Washington has been increasingly leaning on the government- sponsored enterprises to do more to back the U.S. mortgage market. The Senate Banking Committee approved legislation last week that overhauls their oversight while also requiring the two to help foot the bill for a federal program insuring mortgages for struggling borrowers.

Ofheo has also lifted portfolio restrictions and eased their capital constraints while lawmakers temporarily raised the limits on loans the companies can buy from $417,000 to $729,750 to help back the market. The companies are now lobbying Congress to make some of those changes permanent.

Negative Assets

Lockhart has pushed for stronger oversight and this month said the companies are a ``point of vulnerability'' to the U.S. financial system because their liabilities are so high. The fair value of Freddie Mac's assets dropped to negative $5.2 billion in the first quarter. Fannie Mae's fell 66 percent to $12.2 billion.

``Flawed appraisals artificially inflate home prices and are often a sign of mortgage fraud and undue influence on appraisers,'' Ofheo and Cuomo's office said in a joint statement when they announced the deal. It will likely prohibit lenders from also using appraisals from firms they own or control in processing loans sold to Fannie Mae or Freddie Mac.

Because Fannie and Freddie control so much of the market, the OCC said the new policy ``would impose new structural and organizational requirements on lenders accountable for financing an overwhelming portion of the U.S. residential real estate business.''

Lacking Authority

Ofheo didn't follow the proper rules to make the change and doesn't have the authority to set policies affecting U.S. banks regulated by the OCC, Dugan said. The appraisal code conflicts with current bank laws, would result in a ``significant and costly change'' in lending practices and will not apply to national banks, he said.

Dugan said he is concerned that ``major portions of the code will undermine, rather than enhance, the quality and reliability of appraisals.

``Second, the application of the code will unnecessarily raise mortgage origination costs for lenders, thereby increasing the cost of mortgage loans for consumers, without actually enhancing protections and other consumer benefits,'' he said.

Created by Congress to increase homeownership, Fannie Mae and Freddie Mac have this year become one of the few avenues for new mortgage financing as competitors scaled back amid record increases in delinquencies and defaults. Their share of the conforming mortgage market, or new loans of $417,000 or less, almost doubled to 81 percent in the first quarter.

The companies make money by holding mortgage assets and on guarantees of mortgage-backed securities they create out of loans from primary lenders. They've posted three straight quarterly losses, including $3.9 billion at Freddie Mac, amid the worst surge in mortgage defaults in seven decades.

The S&P/Case-Shiller home-price index dropped 14.4 percent in March from a year earlier, the most since the figures were first published in 2001. Separate figures from the Commerce Department showed sales of new homes were the second-lowest since 1991 in April.

To contact the reporter on this story: Dawn Kopecki in Washington at dkopecki@bloomberg.net.

Last Updated: May 27, 2008 16:55 EDT