The problem was a basic one. In good times, banks thrive by loaning money long term, at a relatively high interest rate, using short-term funds that they borrow at a lower rate. But in hard times, their short-term funds can disappear if investors or depositors have reason to worry about the bank's solvency.
When such doubts start spreading systemwide, the panic is generally stopped by the entry of a "lender of last resort." In other words, by the government or central bank. It's a lesson that led to the Federal Reserve's creation after a banking panic in 1907. And it's a lesson that proved vital to quelling the panic of 2008.
As the mortgage crisis evolved into a financial crisis, the Fed and later the Treasury swung into action. From late in 2007 through early in 2009, the Fed gradually rolled out a succession of programs designed to provide credit where private-sector confidence had evaporated. They had abbreviations only a banker could love: the TAF, the TSLF, the PDCF, the AMLF, the CPFF, the MMIFF, the TALF.
If the alphabet soup sounds a bit like the New Deal, that's not by accident. The Fed's vice chairman at the time, Donald Kohn, recalls that Bernanke liked to say that although he didn't agree with everything Franklin Roosevelt did to overcome the Great Depression, he did admire the way the president kept trying new ways to strengthen the economy.
When the investment bank Lehman Brothers went bankrupt, financial markets reached their point of maximum uncertainty. Was the crisis spinning out of control? The fear spread into money-market funds, where some 30 million Americans held cash. "When that market dried up and came under pressure," recalls Paulson, "my phone was ringing off the hook."