The fed stepped in and offered to make emergency loans to banks. The idea was to prevent sound banks from collapsing just because lenders were panicking. Government enacted TARP that is troubled asset relief program called by laymen as Bank bailout. This initially earmarked $700 billions to shore up the banks. It actually ended up spending $250 billion in bailing out banks and the rest was expanded to help automakers, AIG and homeowners.
Treasury also conducted stress test on the largest Wall Street banks. Government accountants swarmed over banks balance sheet and publicly announced which one were sound and which one needed to raise money. This eliminated some of the uncertainties that had paralysed lending among institution.
In January 2009, Congress poured $800 billion in the economy through new spending and tax cuts. This helped slow the free fall in spending, output and employment.
In 2010 Congress passed a financial reform called dodd-frank law. It took steps to increase transparency and prevent banks from taking too much risk. It set up consumer protection bureau to reduce Predatory lending.
One key thing that led to this crisis was perverse incentive. It means a situation when policy ends up having a negative affect, the one that wasn't intended. Like mortgage brokers got bonuses from lending out more money but that leds them to make risky loans which hurts profits in the end. This led to moral hazard which means a situation when one person takes more risk because someone else bear the burden of that risk. Bankers and lenders were willing to lend the subprime borrowers as they planned to sell mortgage to somebody else.
Everyone thought that they could pass the risk up the line.
The former fed chairman Alan greenspan has summed up really nicely when he said, " If they are too big to fail they are too big."
