Updated from 3:45 p.m.

Washington Mutual ( WM) plunged 7% after New York's attorney general accused the lender of engaging in a scheme to inflate house appraisals.

Attorney General Andrew Cuomo sued First American's ( FAF) real estate appraisal subsidiary, eAppraiseIT. First American is a big title insurer.

A suit filed in New York State Supreme Court by Cuomo's office says First American "caved to pressure" from Seattle-based WaMu to use a list of appraisers who inflated the values of thousands of homes. Cuomo also alleges that executives at eAppraiseIT "knew their behavior was illegal, but intentionally broke the law to secure future business with WaMu," his office said in a release.

WaMu said it would investigate and suspended its business with the First American unit.

"We have absolutely no incentive to have appraisers inflate home values," WaMu said. "In fact, inflated appraisals are contrary to our interests. We use third-party appraisal companies to make sure that appraisals are objective and accurate."

"The complaint filed today by the New York Attorney General against First American and our eAppraiseIT subsidiary has no foundation in fact or law," First American said in a statement. "The Attorney General's allegations, largely based on a handful of e-mails that have been taken out of context, or mischaracterized, and an incomplete review of the facts, belie our record of compliance with applicable law.

"The program called into question today by the Attorney General has been vetted and approved by the federal regulator responsible for oversight of such programs," First American continued. "We welcome the opportunity to now present all the facts before an impartial third party."

Shares of WaMu tumbled $2 to $25.88.

From April 2006 through October 2007, eAppraiseIT provided approximately 262,000 appraisals for Wamu, Cuomo's office said.

The news comes as housing-related stocks suffer another massive selloff as investors worry about financial firms' potential losses from rising mortgage defaults.

On Thursday, big lender Countrywide Financial ( CFC) fell 7%, and mortgage insurers PMI Group ( PMI), MGIC Investment ( MTG) and Radian Group ( RDN) tumbled between 9% and 14%.

Cuomo is seeking to end the relationship between Wamu and First American, as well as to get penalties and disgorgements from First American and eAppraiseIT.

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