The Treasury said it would require the companies, whose massive losses threatened the financial system after the housing bubble burst in 2007, to shrink their investment portfolios more quickly and turn over any profits to taxpayers.

Previously, the companies, which buy mortgages from lenders and repackage them as securities for investors, were required to make a 10 percent dividend payment to the Treasury. At times, they had to borrow from the Treasury just to make the payments. Now, they simply won't be able to retain any profits.

The new terms mark the latest step in Fannie Mae and Freddie Mac's fall from grace. The two companies were highly profitable and politically powerful as the U.S. housing bubble built. Now, most officials think they should eventually be dissolved.

Lawrence Yun, chief economist at the National Association of Realtors, said the changes effectively make the two companies government utilities. "That new institution will be such that it's not going to be a for-profit company. It's just going to generate enough revenue to operate," he said.

Fannie Mae and Freddie Mac were seized by the government at the height of the financial crisis in 2008 as mortgage losses threatened their solvency. Since then, they have drawn a total of $188 billion in taxpayer funds to stay afloat, while paying more than $45 billion in dividends.

At the start of next year, the unlimited support the Treasury extended to the two companies will expire. After December 31, Fannie Mae's bailout will be capped at $125 billion and Freddie Mac will have a limit of $149 billion.

The companies' corporate debt price rallied as the new policy alleviated the need for Fannie Mae and Freddie Mac to borrow from the government just to make dividend payments, putting them in a better position to service their debt.

"You fixed the major flaw in the initial agreement," said Jim Vogel, interest rate strategist at FTN Financial in Memphis, Tennessee.

However, their preferred shares lost more than half their value in heavy trading as investors saw the plan as undercutting the ability of either company to ever emerge from government conservatorship as profitable entities. Their common shares also fell.

With the U.S. housing market showing signs of improvement and Fannie Mae and Freddie Mac reducing their portfolios of loans with poor credit quality, the government-controlled companies posted strong profits in the second quarter of this year.

The Treasury said the altered bailout terms would ensure that "every dollar of earnings that Fannie Mae and Freddie Mac generate will be used to benefit taxpayers for their investment in those firms."

The American Bankers Association, which represents all U.S. banks, praised Treasury's move and said it helps ensure that taxpayers will ultimately be repaid.

INVESTMENT PORTFOLIOS

Although the Treasury said the changes would accelerate plans to eventually shut the companies down, the announcement did little to address how that might be achieved or how the government's footprint in the mortgage finance market might shrink. Fannie Mae, Freddie Mac and the Federal Housing Administration finance nine out of every ten new home loans.

Early last year, the administration proposed three options to reshape the housing finance system, ranging from privatizing the market almost entirely to allowing the government to insure certain mortgages. But the administration has never provided detailed plans on how to move forward.

While Democrats and Republicans agree on the need to reduce the government's role in housing finance, they disagree on how sharply it should be scaled back.

Representative Elijah Cummings, a Democrat heavily involved in housing issues, applauded the new terms, which will also require the companies to annually submit plans to Treasury on how they will protect taxpayers' interests.

In contrast, Republican Representative Scott Garrett, who chairs a congressional panel that oversees the companies, characterized the changes as the administration kicking the can down the road and avoiding crucial policy decisions.

As part of the new terms, Fannie Mae and Freddie Mac will be required to reduce their investment portfolios at an annual rate of 15 percent instead of the previous 10 percent. That will put each of them on track to cut their portfolios to a targeted $250 billion in 2018, four years earlier than planned.

Fannie Mae's investment portfolio, valued at $673 billion as of the second quarter, holds distressed loans and mostly mortgages that were originated before 2008. Freddie Mac's investment portfolio was valued at $581 billion as of June.

During the years of the housing boom, their portfolios generated enormous profits.

(Additional reporting by Richard Leong and David Gaffen in New York and Jason Lange in Washington; Editing by Chizu Nomiyama, Neil Stempleman and Tim Ahmann)

• A Permanent Economic Emergency