Sept. 30 (Bloomberg) -- Fannie Mae's shares fell to a 13- month low and its bonds weakened as the U.S. Justice Department considers whether to conduct a criminal investigation into accounting fraud at the largest source of U.S. mortgage money.

The U.S. Office of Federal Housing Enterprise Oversight, Fannie Mae's regulator, referred the results of its findings into the company's bookkeeping to prosecutors, who have yet to determine whether a probe is warranted, said a person familiar with the matter who declined to be identified. Earlier today, the Wall Street Journal reported that an investigation was opened, citing lawyers it didn't identify.

Ofheo last week said it found the Washington-based, government-chartered company used improper ``cookie jar'' reserves and deferred expenses to smooth earnings and meet executive bonus targets. A Justice Department investigation would indicate errors uncovered by Ofheo go beyond how the company interpreted accounting rules, analysts said.

``We were not expecting the DOJ to investigate this matter and believe that this event highlights the serious nature of the issues,'' said Edwin Groshans, an analyst at Fox-Pitt Kelton Inc. in New York. Groshans rates Fannie Mae ``underperform.'' He declined to comment further.

Fannie Mae spokesman Brian Faith, declined to comment, as did Justice Department Spokesman Bryan Sierra and Ofheo Spokeswoman Corinne Russell. Another Fannie Mae spokesman, Chuck Greener, told the Journal the company had no knowledge of an investigation.

Ohio Attorney General Jim Petro said he will investigate whether Fannie Mae's accounting caused the state's five public pension funds to lose money. In a press release, Petro said his office is examining the period from October 1999 through September 2004 to determine the extent of the losses.

Growth `Throttled'

Shares of the company dropped $2.85, or 4.30 percent, to $63.40 -- the lowest since August 2003 - on the New York Stock Exchange. They are down 16 percent since Sept. 21, erasing about $11 billion of market value, after Ofheo said Fannie Mae violated accounting rules and it had ``doubts'' about the validity of earnings.

The extra yield demanded by investors to own Fannie Mae's 4 5/8 percent notes maturing in October 2014 rather than 10-year Treasuries widened 1.5 basis points to 54.9 basis points, according to Merrill Lynch & Co. A basis point is 0.01 percentage point. The gap is the biggest since July.

Fannie Mae's ``growth will be throttled because of the uncertainty,'' said James McGlynn, who bought shares of competitor Freddie Mac last year after that company restated its earnings by $5 billion. ``It seems early to assume that no more `shoes' will fall,'' said McGlynn, who is part of a team that manage $6 billion at Cincinnati-based Summit Investment Partners.

Government Ties

Congress created Fannie Mae in 1938 to increase financing for home mortgages. The company makes money on the difference between its costs to borrow in the bond market and the returns on mortgages it buys from lenders. It also earns money by charging lenders fees to guarantee credit on mortgage bonds.

Fannie Mae and Freddie Mac, the second-largest source of mortgage money, own or guarantee almost half the $7.3 trillion mortgage market. After the federal government, Fannie Mae is the second biggest debtor in the U.S., with $942 billion as of July. Fannie Mae earned $7.91 billion in 2003, double that of 1999.

Franklin Raines, the chief executive of Fannie Mae, is scheduled to testify at an Oct. 6 Congressional hearing on Ofheo's report. The regulator also said Fannie Mae improperly account for financial contracts designed to reduce the effects of swings in interest rates on its $895 billion portfolio.

Regulation Efforts

Ofheo's findings ``point out the need for that strong regulator that I've called for,'' Treasury Secretary John Snow said in a Sept. 28 interview. Snow has said tighter regulation would help dispel investor and taxpayer concerns about accounting errors damaging the housing market.

The Bush administration wants a stronger regulator with authority over capital standards, new lines of business, and other basic operations at Fannie Mae and Freddie Mac.

Representative Michael Oxley of Ohio, a Republican and chairman of the House Financial Services Committee responsible for Fannie Mae, yesterday gained authority to subpoena company executives for its hearing Oct. 6. Raines and Chief Financial Officer J. Timothy Howard will testify, the company said.

Ofheo's report last week placed much of the blame on Howard, calling him the ``chief architect'' of the accounting policies. Fannie Mae hasn't made Howard available for comment.

Political Ties

Raines was a former budget director in the Clinton administration. Ofheo's director, Armando Falcon, was appointed to his position by Clinton in 1999.

Lawmakers such as Representative Richard Baker of Louisiana, who is the second-most most senior Republican on Oxley's Committee, have criticized Ofheo for not catching accounting errors at Fannie Mae and Freddie Mac earlier.

``People know that in the current public climate, there are severe political pressures on Ofheo and that have had a largely adversarial relationship with the companies they regulate,'' said Orin Kramer, head of the New Jersey State Investment Council. The Bush administration would like tougher scrutiny, Kramer said.

Kramer is a campaign fund-raiser for Democratic Presidential candidate John Kerry in New York State and the campaign finance manager for U.S. Sen. Jon Corzine of New Jersey. The council makes investment decisions for more than $70 billion in state pension and other investments.

Freddie Mac Probe

Competitors including American International Group Inc. and GE Capital Corp. formed in 1999 a lobbying group, FM Watch, to push for legislation that would end what it says are Fannie Mae's unfair borrowing advantages and expansion into new businesses that have little to do with its government charter.

The Justice Department last year opened a criminal investigation into McLean, Virginia-based Freddie Mac after the company said it understated three years of income by $5 billion because executives manipulated accounting to make earnings less volatile. Freddie Mac ousted four top officials between June and August last year, including Chief Executive Officer Leland Brendsel, and was fined $125 million by Ofheo.

The Justice Department's inquiry isn't expected to produce indictments, the Journal said, citing lawyers briefed on the matter it didn't identify.

``We have not been fans of Fannie Mae or Freddie Mac debt for much of the past year or year and a half,'' said Marc Seidner, who oversees $21 billion of bonds at Standish Mellon Asset Management in Boston. ``These are large entities, they have very little transparency and very large derivatives positions. And quite frankly the fixed income market you're not rewarded for the risks associated with investing.''

Higher Rates

Fannie Mae's troubles may lead to higher mortgage rates for consumers as its growth slows, said Craig Smith, an analyst at Babson Capital Management LLC in Boston. The firm owned 881,000 Fannie Mae shares as of last week.

He estimates average mortgage rates may rise by 10 basis points. The average rate on a 30-year fixed-rate mortgage is 5.70 percent, according to Freddie Mac.

To meet Ofheo's capital requirements, Fannie Mae may reduce mortgage loan and securities purchases by about $100 billion over the next 12 months, said analyst Jonathan Gray of Sanford C. Bernstein & Co. in New York. The company bought $175 billion this year through August. The company owns $895 billion of mortgage assets, down from $898 billion in December.

Fannie Mae has 270 days to increase capital to a level 30 percent above the required minimum, according to an agreement the company reached with Ofheo. Its core capital was $36.115 billion as of June 30, more than its minimum capital requirement of $31.188 billion, Ofheo said today.

To contact the reporter on this story: Albert Yoon in New York at at ayoon@bloomberg.net James Rowley in Washington at jarowley@bloomberg.net.

Last Updated: September 30, 2004 17:42 EDT