The 2008 recession was a significant economic downturn triggered by a collapse in the real estate market, primarily due to the failure of mortgage-backed securities (MBS). These securities were created by bundling various mortgages, including both high-risk subprime loans and safer mortgages, which misled investors about their actual risk. As defaults increased, the value of these MBS plummeted, leading to substantial losses for investment banks heavily invested in them, resulting in insolvency for many institutions.
In response to the crisis, the Federal Reserve implemented several unprecedented monetary policy measures aimed at stabilizing the financial system. Initially, the Fed allowed investment banks to access discount loans, which are typically reserved for commercial banks. This move provided much-needed liquidity to these banks, enabling them to avoid selling off securities at a loss. Additionally, the Fed exchanged $200 billion in Treasury securities for MBS, allowing banks to replace their worthless collateral with more stable assets.
One of the critical interventions was the Fed's assistance in the acquisition of Bear Stearns by JPMorgan Chase. The Fed believed that allowing Bear Stearns to fail would trigger a broader financial panic, worsening the recession. However, when Lehman Brothers was allowed to go bankrupt later in September 2008, the Fed recognized the moral hazard associated with bailing out failing institutions. Moral hazard refers to the risk that entities will engage in risky behavior if they believe they will be rescued from the consequences.
In October 2008, the Troubled Asset Relief Program (TARP) was introduced, marking a historic shift in government policy. TARP involved the federal government providing funds to commercial banks in exchange for partial ownership, a move that had never been undertaken before. This program aimed to stabilize the banking sector and restore confidence in the financial system.
Through these decisive monetary policy actions, the Federal Reserve mitigated the impact of the Great Recession, preventing it from escalating into a crisis comparable to the Great Depression. While the long-term effects of these policies are still debated, they played a crucial role in stabilizing the economy during a tumultuous period.
