By Corbett B. Daly and Kevin Drawbaugh

WASHINGTON (Reuters) - The former chief of Fannie Mae, the top U.S. mortgage finance company whose purchase of risky home loans led to a massive government bailout, on Friday apologized for the company's failings, though he defended the lavish compensation of top executives as necessary.

Even as Daniel Mudd, who was ousted as chief executive when government regulators seized Fannie Mae in September 2008, accepted responsibility, he said the company's business model created an unmanageable situation.

"I was the CEO of the company and I accept responsibility for everything that happened on my watch," Mudd said at a hearing before a congressional investigative panel assigned to probe the origins of the 2007-2009 financial crisis.

A former government regulator who oversaw Fannie and its sister firm Freddie Mac gave a more blistering assessment.

Fannie Mae, along with Freddie Mac, was placed under the control of regulators when its business was in disarray and the U.S. housing market was in free-fall.

The two companies have so far received more than $125 billion in direct government support, and have said more aid will be needed. The Treasury Department has pledged to backstop their losses through 2012, without limits.

The spectacular failures of the two firms -- both government-sponsored enterprises (GSEs) created to expand mortgage finance but which operated as private, profit-making companies -- marked a turning point in their controversial history and in the U.S. housing market.

Congress and the Obama administration, consumed for the past two years with shoring up Wall Street and the banking system, have barely begun to figure out how to fix the GSEs, which own or guarantee half of all U.S. residential mortgages.

"The Fannie and Freddie model of publicly traded and privately held government-chartered companies is inherently flawed," said Armando Falcon, former regulator of the two companies in testimony following Mudd's at the hearing held by Congress' Financial Crisis Inquiry Commission.

Falcon, former director of the defunct U.S. Office of Federal Housing Enterprise Oversight, said the present set-up gives the GSEs "market and political power that ... breeds arrogance, greed, excessive risk taking and abuse."

Falcon and his successor, James Lockhart, told the panel that Fannie and Freddie used their octopus-like reach in Washington to ensure that any regulations regarding their business would not impact their ability to make massive profits during the boom years.

COMMISSION PROBES SECURITIZATION BREAKDOWN

Organized by Congress, the commission has held three days of public hearings, focusing on the breakdown of the home mortgage securitization market and its role in triggering a crisis of confidence that paralyzed global banking in 2008 and tipped the U.S. economy into a deep and long recession.

At the outset of Friday's hearing, Mudd apologized and accepted blame. But he said the root cause of the GSEs' problems was their business model.

In a historic home price slump, the firms could not maintain their mandated balance between "financial goals" of growth and profitability, and "mission goals" of providing liquidity and housing finance for low-income Americans, he said.

"I sought to balance the fine points of mission and business insofar as I could understand them, with the support of regulators and policy makers. That was no longer possible by September 6, 2008, and I am sorry for that," he said.

"There have been suggestions that Fannie Mae subordinated its mission to the pursuit of higher profits, but I beg to differ," he said, adding that homeownership rates were too high ahead of the financial crisis.

The commission's chair, Phil Angelides, was skeptical.

"Even today at Fannie Mae, ... I don't think there's been the self-examination that will lead to the real reforms that we need," Angelides told Reuters.

"They borrowed cheaply. They earned on that cheap borrowing, which is much like what the big banks on Wall Street are doing today," he said. "They make profits and they pay themselves huge compensation."

Mudd, who was paid $13.4 million in 2007, told the panel that handsome salaries were necessary to attract and retain top talent.

"The pay for being in a public service organization unfortunately wouldn't be sufficient to attract" experienced people, Mudd said, adding that the compensation was 70 percent of what those employees could get elsewhere.

Three quarters of a "huge amount of money is still a huge amount of money," commissioner Heather Murren shot back.

FINANCIAL REFORMS LACK GSE PLAN

Although analysts expect Congress to send a final bill on tightening regulation of banks and capital markets to President Barack Obama this year, it will lack a plan for reshaping the GSEs.

U.S. Treasury Secretary Timothy Geithner said last month that mortgage finance needs a revamp. The Obama administration is expected to issue for comment on Thursday a series of basic questions about the future of housing finance.

Mudd told the commission that fully privatizing the GSEs is unrealistic and government will have to play some role, considering that roughly 90 percent of home loans today have some sort of governmental involvement.

(Editing by Leslie Adler)