updated 12/12/2006 6:26:29 PM ET 2006-12-12T23:26:29

Fannie Mae on Tuesday sued KPMG LLP, its former outside auditor, for $2 billion alleging negligence and breach of contract that resulted in the mortgage leader having to restate billions of dollars in profit.

KPMG LLP, the U.S. unit of Big Four accounting firm KPMG International, worked for Fannie Mae for about 35 years, providing audit and other services until it was terminated in December 2004, according to the lawsuit.

Last week, Fannie Mae, which finances four out of every five home loans in the United States, was forced to erase $6.3 billion in reported profit from the start of 2001 through June 30, 2004, after a review ordered two years ago by the Securities and Exchange Commission.

“KPMG’s negligence has forced Fannie Mae to undertake one of the largest accounting restatements in history,” according to the 52-page lawsuit filed with the Superior Court of the District of Columbia.

“KPMG engaged in a ‘check-the-box’ approach to its audits, failing to exercise professional judgment and independent scrutiny,” that resulted in more than $2 billion in damages for Fannie Mae, including more than $1 billion “to re-create and correct historical financial statements KPMG negligently approved,” the suit alleges.

KPMG spokesman Tom Fitzgerald said the company plans to pursue its own claims against Fannie Mae as part of pending litigation in federal court.

Legal experts also questioned Fannie Mae’s claims.

“I would be blown over that somehow Fannie Mae had out-of-pocket costs of $2 billion, or $1 billion, resulting from restatements,” said James Cox, a professor of corporate and securities law at Duke University Law School in Durham, N.C.

Cox, a former Fannie Mae stockholder, said the company will have a difficult time proving that it was harmed more than investors who bought Fannie Mae shares at inflated prices when it was overstating its earnings.

The company’s shares were trading at more than $85 per share in mid-2001, but were valued at about half that much five years later.

Cynthia Williams, a professor at the University of Illinois College of Law in Champaign, agreed and said Fannie Mae blaming its own misstatements on KPMG is unusual and “you have to ask: ‘Where were they?’ ”

But James Lockhart, director of the Office of Federal Housing Enterprise Oversight, which regulates Fannie Mae and Freddie Mac, said the lawsuit “is appropriate and consistent” with the findings of his agency’s reports.

Fannie Mae’s suit includes 17 complaints, nine for contract breaches and eight for malpractice or negligence. The suit alleges that at least 30 accounting policies approved by KPMG were not consistent with generally accepted accounting principles.

Specifically, KPMG conducted a special consulting project to analyze all of Fannie Mae’s proposed polices regarding hedges, or financial transactions in which the company tries to limit exposure to fluctuations in interest rates, and concluded all would be in compliance with new rules from the Financial Accounting Standards Board. KPMG, acting as an auditor, then approved all of Fannie Mae’s hedge transactions, which later had to be restated, according to the suit.

Another alleged breach involved amortization, in which Fannie Mae accounts for purchase discounts or premiums and other deferred price adjustments in mortgages. Again, KPMG approved accounting polices that departed from accepted accounting requirements, according to the suit.

And after Freddie Mac restated its financials in 2003 following misstating earnings by about $5 billion — mostly underreported — for 2000-2002, Fannie Mae asked KPMG to review its own policies to see if Freddie Mac’s problems were applicable.

“KPMG again gave Fannie Mae a clean bill of health,” according to the suit.

Fannie Mae also notes in its suit the SEC’s separate actions against KPMG LLP in which Xerox Corp. and Gemstar-TV Guide International Inc. settled cases regarding manipulations of past financial statements. KPMG agreed to pay fines in both cases, which also resulted in charges against Xerox and Gemstar executives.

SEC spokesman John Nester declined comment on the suit.

Shares of Fannie Mae rose 34 cents to close at $60.19 on the New York Stock Exchange, near the upper end of a 52-week range of $46.17 to $62.37.

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