Just to set the record straight…

Fannie and Freddie are GSEs because there is an implicit guarantee. Not just by the government, but by the tax-payers.

The implicit guarantee encouraged the capital markets to offer them a lower cost of capital, so they can borrow more cheaply than traditional lenders. Unlike the view of some posters on the ABC blog, the government is not the source of their funding.

The implicit guarantee also allowed them to get big, and as they got bigger, they became more of a systemic risk. That is, their size posed a risk to the entire system. Their more recent expansion into trading and holding sub-prime (higher-yielding) securities, along with the decline in home values, eroded their capial base, which made the Asian banks, among others, begin to seriously question their solvency.

Most people know what happens from there, but the short of it is: the shareholders and creditors forced the government make its implicit guarantee explicit.

As for Palin’s comment:

The fact is that Fannie Mae and Freddie Mac have gotten too big and too expensive to the taxpayers. The McCain-Palin administration will make them smaller and smarter and more effective for homeowners who need help

If anything, Fannie and Freddie made financing cheap and encouraged the market to provide unrealistically generous terms for sub-prime buyers of homes. This encouraged more home-buying, inflated the bubble, and increased the size of the systemic risk posed by Fannie and Freddie.

The only thing that was expensive was the option value of the put on Fannie & Freddie’s massive exposure to the housing market. But no one was pricing that. Instead, everyone was focused on recycling foreign reserves into higher-yielding, implicitly guaranteed paper — GSE paper. This is Bernanke’s “savings glut.”

We —and not just Americans— received the benefit of this cycle. We had cheap stuff made in China, increased profits at our MNCs, a growing stock market, unheard-of valuations for our homes, in which we invested unheard-of amounts in new kitchens, bathrooms, and other stranded assets.

China has been able to employ record amounts of people, raise their standards of living, and though under continued criticism for their general mode of government, invest in the infrastructure necessary to provide future growth.

The pending insolvency of the GSEs and general seizures in the credit markets, however, put a stop to the salad days. Spreads widened. Buyers of GSE paper began to lose interest. People asked, if the spread for paper from a implicitly backed GSE is widening, shouldn’t it also be wider for everything else? Credit choked up, and the “recycling” phenomenon began to slow down. The problem was, the recycling phenomenon is responsible for ensuring capital flows, which in turn is responsible for maintaining the housing market, etc. Hence, conservatorship.