The government on Wednesday lifted limits on the amount the two largest mortgage finance companies can invest in home loans, a move that could unleash billions more dollars to stabilize the housing market and fend off a possible recession.

Restrictions were removed despite Fannie Mae's announcement, also on Wednesday, that it suffered a staggering quarterly loss of $3.6 billion as defaults and foreclosures surged. The Office of Federal Housing Enterprise Oversight took the action in light of the signs the companies have recovered from accounting scandals, such as the resumption of timely financial reports.

Lifting the caps on Fannie Mae's and smaller rival Freddie Mac's combined portfolios of $1.4 trillion will give them more ability to support the slumping housing market by increasing mortgage investments and bond programs.

Mortgage lenders see the two companies as the last bastions of funding since investors, who consider them as having implied government backing, are still buying their debt amid a widespread credit crisis.

Investors welcomed the action with some skepticism.

It may be the first step in easing tight credit markets but Fannie Mae's Chief Executive Officer Daniel Mudd, speaking on a conference call, underscored that the company's first priority is to preserve capital, not to grow.

The GSEs are really looked to as the last great hope for the housing market, said Malcolm Polley, chief investment officer at Stewart Capital Advisors in Indiana, Pennsylvania. To the extent that they will be able to grow their portfolio, their earnings will grow.

On March 1, OFHEO will remove the caps on the companies, known as government-sponsored enterprises, that have restricted their growth since they committed more than $11 billion in accounting errors earlier this decade.

Washington-based Fannie Mae posted a $3.80 per share net loss for the fourth quarter -- much worse than analysts' expectations, according to Reuters Estimates, of a loss of $1.39 per share.

The company had a profit of $604 million in the year-earlier period while in November it reported a $1.52 billion third-quarter loss.

Losses at Fannie Mae have constrained its ability to support housing in what CEO Mudd said was the most challenging market since the dislocation after World War II. At the same time, the company is under increased pressure from lawmakers to provide greater support to the housing market.

Key to Fannie Mae's ability to sustain losses in 2008 and perhaps 2009 is the company's capital, which rose last quarter to $3.9 billion above its regulatory minimum, analysts said. The increase resulted from $7.8 billion in sales of preferred stock, minus the quarterly loss, dividends and investments.

Our strategy for moving through another tough year is to protect and conserve our capital base, and control credit losses, Mudd said in a statement.

Analysts said lifting investment limits is not a panacea. RBS Greenwich Capital, which underwrites GSE debt, said the current housing situation does not sound like an environment that facilitates portfolio growth.

Fannie Mae said it will suffer bigger losses on home loans than it forecast just three months ago as declines in house prices accelerate and foreclosures rise. It increased its credit loss ratio forecast to a range of 11 basis points to 15 basis points in 2008 from the 8 to 10 basis points it forecast just three months ago.

Credit losses were 5.3 basis points in 2007 and 2.2 basis points in 2006, Fannie Mae said.

Fannie Mae's report is disturbing, said Peter Kenny, managing director at Knight Equity Markets in Jersey City, New Jersey. It confirms the market's expectation, or fear, of another shoe to drop.

Falling home prices after years of loose underwriting standards and a speculative frenzy have filtered from risky subprime loans to the prime loans that make up most of Fannie Mae's business, shocking investors who thought the company was better protected. Home prices will probably now fall as much as 7 percent this year, more than the 5 percent decline initially forecast, Fannie Mae said.

Fannie Mae said its fourth quarter results were largely driven by a $3.2 billion loss on derivative contracts used to hedge its investment portfolio as interest rates declined.

The earnings report initially drove Fannie Mae shares to a 12-year low at $25.33, but the announcement on portfolio caps sent them rocketing as much as 17 percent higher. Shares were just 1 percent higher in late afternoon trade.

Fannie Mae shares have fallen 33 percent this year through the market close on Tuesday, compared with a 3.8 percent drop in the KBW Mortgage Finance index .MFX over the same period.

Freddie Mac reports its fourth quarter results on Thursday, with another large loss is expected.

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