FED Liquidity Policy during the Financial Crisis: Playing for Time

This paper focuses on how the Federal Reserve (Fed) responded to the early stage of the international financial crisis, from 2007 through 2008, which it characterized as a short-term liquidity problem, despite growing evidence of potential insolvencies among some of the largest banks and investment banks [1]. The Fed provided large amounts of liquidity to both domestic and international institutions when credit risk spreads suddenly widened in September of 2007 and still more liquidity when these spreads virtually exploded in September of 2008 in the wake of the collapse of Fannie Mae and Freddie Mac and the bankruptcy of Lehman Brothers [2]. We argue that signs of increasing financial fragility and potential insolvencies appeared much earlier than fall of 2007. If these had been recognized and acted upon by the regulatory authorities, then it is possible that the most serious financial crisis since the Great Depression might have been substantially mitigated. While it is inherently difficult to disentangle issues of illiquidity from insolvency, the failure to recognize and address the insolvency problems in several major institutions delayed necessary adjustments and undermined confidence in the financial system.