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The stock market looked past grim earnings results at

Fannie Mae

( FNM) on Tuesday and focused on the prospect of a wider role for the government-backed mortgage giant in the floundering U.S. housing market.

Fannie reported a $2.19 billion first-quarter loss before Tuesday's opening bell that caught Wall Street off guard and sent stocks tumbling. The largest buyer of U.S. home loans said it will raise $6 billion in fresh capital -- a move federal regulators have demanded -- and it slashed its quarterly dividend payments by 29% to preserve cash. It also reported that its loan-loss provision soared to $5.2 billion from $249 million, as CEO Daniel Mudd said he doesn't expect a real recovery in the U.S. housing market before 2010.

Nevertheless, shares of Fannie reversed into positive territory in early trading after it reported results, recently adding $1.46, or 5.1%, to $29.75. The rally came as the Office of Federal Housing Enterprise Oversight, the federal regulator charged with monitoring government-sponsored housing giants Fannie and

Freddie Mac

( FRE), announced it would lift a consent order it placed on Fannie two years ago and lower the company's capital reserve requirement to 15% from 20% after the capital raise.

Cramer: Fannie Packs a Value Punch

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Fannie and Freddie both were recently embroiled in massive accounting fraud scandals, resulting in tightened oversight restrictions from OFHEO, the federal regulator charged with monitoring the companies. Now, amid pressure to provide relief to in the secondary mortgage market where credit conditions have largely dried up, lawmakers are loosening those restrictions and calling for both companies to play a larger role in helping to stabilize the housing market.

OFHEO lowered its requirement on Fannie to hold a surplus over minimum capital levels to 20% from 30% in mid-March in return for the company's commitment to raise new capital. Now OFHEO will lower the surplus to 15% after the capital has been raised, and it said it will lower it 5 basis points further in September. Freddie is expected to report results next week.

Howard Shapiro, analyst with Fox-Pitt Cochran Caronia, says that investors had expected Fannie's quarterly results to be ugly, but they were pleased that the company would be raising less capital than many had suspected it would. Also, increased fee rates and profit margins on new business were a positive sign for the future, and OFHEO's decision to further loosen the regulatory reins will allow Fannie to grow its business for the future despite the difficulties it's currently experiencing.

"This means

Fannie can put more capital at risk to help our mortgage market," says Shapiro.

Fannie's expansion in the mortgage market will ease credit jitters for investors because the firm has implicit backing from the federal government. The

Federal Reserve

has already signaled that it will backstop the banking system when it helped

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JPMorgan Chase

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buy a near-bankrupt

Bear Stearns

( BSC) in March and extended emergency liquidity to investment banks in return for illiquid collateral, like mortgage-backed securities. Many investors viewed the Fed's actions as evidence that it would also backstop Fannie and Freddie.

Both companies are suffering at the hands of a nasty downturn in the U.S. housing market, where prices are recording their largest declines on record since the Great Depression. The mortgage crisis has led to a rash of defaults on home loans in markets around the country, which has in turn provoked a credit crisis on Wall Street and a loss of confidence among investors. Investment banks like

Citigroup

(C) - Get Citigroup Inc. Report

,

Merrill Lynch

( MER) and

Lehman Brothers

( LEH) have posted billions in losses on investments tied to the mortgage market.

Meanwhile,

Bank of America

(BAC) - Get Bank of America Corp Report

, in a Securities and Exchange Commission filing last week, said it hadn't yet decided whether it will take on certain mortgage debt from

Countrywide Financial

( CFC) when the bank completes its acquisition in the third quarter.

In this context, Fannie and Freddie are referred to by skeptics as a "trillion-dollar mortgage time bomb." An analysis by Standard & Poor's recently pointed out that at the end of January, 82% of all mortgages in the U.S. were backed by Fannie or Freddie, up from only 46% in the second quarter of 2007. Meanwhile, Fannie disclosed Tuesday that so-called Alt-A mortgage loans, which are characterized by a lack of credit documentation for the borrower, are an increasing source of financial stress for the company. The loans in question were made at the height of the housing bubble in 2005, 2006 and 2007.

The underwriting standards at the peak of the market were not what they should have been," said Thomas Lund, executive vice president at Fannie Mae, on a conference call with analysts. "That's where we are seeing the disproportionate share of our losses."

Lund also said credit losses were growing the Midwest due to a slowdown in the economy and mounting job losses.

"My guess is that will continue for some period of time," said Lund.

Fannie reported a loss for the quarter of $2.19 billion, or $2.57 a share, compared with the earnings of $961 million, or 85 cents a share, it recorded for the same period last year. Revenue climbed 28% to $3.78 billion.

The bottom-line results missed expectations on Wall Street by a long shot, with analysts expecting a loss of 81 cents a share, according to consensus estimates reported by Thomson Reuters. Top-line results, however, beat expectations, with analysts, on average, forecasting revenue of $1.26 billion for the quarter.

The results included $4.4 billion in losses on mortgage-related securities and $3.2 billion in credit-related expenses due to higher charge-offs amid higher defaults and average loan-loss severities.

The company said it expects "severe weakness in the housing market to continue in 2008," and that will "lead to increased delinquencies, defaults and foreclosures on mortgage loans, and slower growth in U.S. residential mortgage debt outstanding."

To cope with its predicament, Fannie said it will cut its common stock dividend to 25 cents a share from 35 cents a share, starting in the third quarter. That will free up an estimated $390 million a year.

Despite all the disappointments, Mudd said on the conference call that he sees "terrific opportunities" for Fannie going forward as the company is asked to play a larger role in the mortgage market.

"As the market recovers, we will be a prime beneficiary," said Mudd.

Peter Schiff, a longtime housing skeptic who heads Darien, Conn.-based broker-dealer Euro Pacific Capital, says that Fannie will be able to raise fresh capital because of its implied backing by the federal government, but he thinks the company will eventually need to be bailed out by the government, requiring large amounts of currency inflation from the Fed or taxpayer dollars.

"The government is expanding the role of Fannie and Freddie in a desperate attempt to prop up inflated housing prices so they don't become insolvent," says Schiff. "Fannie and Freddie stand behind trillions of dollars in mortgages that are only as good as the value of the homes that collateralize them, but homes are too expensive in this country and prices have to come down if the housing market can recover. People can't buy homes if they're too expensive, unless we start using teaser rates and no down-payments again, which is what got us into this mess in the first place."