The two giant GSEs, Fannie Mae and Freddie Mac, have long imposed an externality on the public. We're now feeling that externality. Fannie and Freddie's primary purpose is mortgage securitization, but they also issue debt to finance their own portfolios of mortgages and mortgage-backed securities (MBS). As the mortgage market has frozen up, Fannie and Freddie have been securitizing mortgages less, and buying mortgages and MBS more. Together they now own or guarantee about $5.3 trillion in mortgage debt, which, according to the FT, is "equivalent to the entire publicly held debt of the US government." The implicit government guarantee of Fannie and Freddie's debt allows them to borrow at artificially low interest rates—the current spread on Fannie's 2-year bonds is considered incredibly high at 74 basis points, but that's still over 20 basis points lower than the current 2-year swap spread, which is 95.5 basis points. This gives Fannie and Freddie an incentive to take on excessive risk in their mortgage portfolios. Buying risky MBS increases the chances that Fannie and/or Freddie will default, and because the government would likely step in to prevent a default, the taxpayers are bearing the costs of Fannie and Freddie's excessive risk. In short, the implicit government guarantee creates a classic externality. How large is the externality? In theory, the size of the externality equals the difference between Fannie and Freddie's artificially low borrowing costs and the borrowing costs they would be paying in the absence of an implicit government guarantee. In practice, however, the size of the externality is more difficult to measure, because there's no way of knowing what their borrowing costs would be in the absence of an implicit government guarantee. Given that Fannie and Freddie have been buying far more subprime securities—and mortgage-backed securities in general—than anyone in the market, it's fair to say that their borrowing costs would be higher than the borrowing costs for other seemingly comparable investors. It's also difficult to determine whether and how much Fannie and Freddie's possible insolvency—and the systemic risks their insolvency poses to the financial markets—are driving up other banks' current borrowing costs. At this point, removing the implicit government guarantee wouldn't cause Fannie and Freddie to fully internalize the costs of their possible failure, because the implicit guarantee has already allowed them to grow so large that their failure poses systemic risks. One externality begets another externality, it seems.