* JSW Steel says police enquire about iron ore purchases
* Morgan Stanley cuts rating to "underweight"
* JFE Holdings says will book appraisal loss of $778 mln on JSW
* Shares down nearly 9 percent on day
(Adds details, comment, background, updates share movement)
By Swati Pandey
MUMBAI, Oct 3 (Reuters) - JSW Steel <JSTL.NS>, India's No. 3 producer, said federal police visited its key plant in southern Karnataka state on Monday morning to seek information regarding iron ore purchases, further hurting sentiment in the beleaguered company.
JSW's shares, which have lost more than half their value this year, fell to a more than two-year low on Monday on concerns regarding the police enquiry and a rating downgrade by a U.S. investment bank.
"Till the time negative news flow continues, investors will stay away from the stock," said Deven Choksey, managing director of KR Choksey Securities.
JSW shares fell 8.8 percent to 540 rupees, their lowest level since July 2009. The shares provisionally ended 7.1 percent lower at 550 rupees on Monday in a weak Mumbai market <.BSESN>.
Japan's JFE Holdings <5411.T>, which holds 14.8 percent in JSW, said on Monday it would book an appraisal loss of around $778 million on its holding in JSW Steel due to a drop in market prices.]
JSW said in a statement that it has been procuring iron ore from various sources for its steel production requirements and "every tonne procured is accounted, paid for and in compliance with applicable rules and regulations."
Earlier in the day, local TV reports said the Central Bureau Of Investigation had conducted raids on the plant, which the company "strongly" denied in its statement.
A number of corruption scandals in India over the past year have thrown the spotlight on the behaviour of leading industrialists and politicians, damaging the government's credibility and making investors skittish.
SUPPLY SQUEEZE
JSW's problems started in August after the country's highest court put an interim ban on iron ore mining in Bellary district of Karnataka due to illegalities, forcing it to run its plants at lower capacity.
Last month, Indian police arrested a powerful opposition politician and mining baron, seizing a trove of gold bars and a $1 million from his base in mineral-rich Karnataka state.
JSW's main plant is in the district. The company has not been accused of any wrongdoing.
Last week, JSW Vice Chairman Sajjan Jindal told reporters it may have to shut its Vijaynagar plant, which accounts for 10 million tonnes of its 14.3 million tonnes total capacity, if ore supplies did not improve.
"All this is sentimentally dampening for the company," said a sector analyst with a local brokerage who did not wish to be identified. "If CBI probes further and finds any irregularities then it will really take the stock down."
Morgan Stanley on Monday downgraded JSW stock to "underweight" from "equal weight" on continued concerns about risk to raw material availability.
"Iron ore situation is becoming tighter in Karnataka, impinging on JSW's ability to source ore and pushing up its production costs," it said in a note, lowering sales volume forecasts for fiscal year 2012 by 2 percent.
"When we superimpose JSW's company-specific issues on the broader macroeconomic risks, we conclude that JSW may have more downside than upside from here, notwithstanding the trailing weak performance," it added.
JSW Steel has underperformed the 40 percent fall in the BSE Metal index <.BSEMET> this year. Its larger rivals Steel Authority of India <SAIL.NS> and Tata Steel <TISC.NS> have fallen 42 and 40 percent, respectively, in the period.
The broader 30-share benchmark BSE index has lost a fifth of its value this year.
(Additional reporting by Manoj Dharra and Sanjeev Choudhary; Editing by Tony Munroe, Aradhana Aravindan)
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