Question

Regarding the 2007-09 Financial Crisis, Was there a bailout of the financial system? Did any organization act as a lender-of-last-resort? Did it “nip the problem in the bud?” What kinds of problems may bailouts lead to?

Answer 1

Yes there was a bailout of the financial system by the Federal Reserve and the US government. The Federal Reserve acted as the Lender of last resort for many banks.

Due to the sub prime mortgage crisis in 2008, most of the big banks who was having exposure to subprime mortgages were in a verge of collapse and at this point Federal Reserve under the influence of US government bailed out almost all of the bank at the same time allowing collapse of some banks like Lehman Brothers. Fannie Mae and Freddie Mac , Bear Sterns, AIG etc were some of the financial institutions that were saved.

Bailout was only one small step in resolving the crisis and it alone will not be able to solve the problem. However Fed has introduced many schemes to tackle the crisis at that time apart from bailout which include providing 0% interest rates, Quantitative Easing etc.

Unnecessary bailout can bring many problems and can expose the inherent problems in the financial system. It can create Moral Hazard among the financial institutions. ie if we bailout one bank for some reasons, it give license to other banks to commit same errors as they will be sure that the central bank will be giving a bail out. It also costly to taxpayers as ultimately its their money that have been used which could have used for constructive ideas or process. Bail out can also reduce the trust among public on the banking system.