I do not think we have exhausted our tool kit. But at the same time, the measures and initiatives that we have taken are to be considered against doing the minimum necessary to restore market efficacy.

From Q&A as reported by Reuters

"I was praised for things I didn't do," Mr. Greenspan said during one of three interviews at his sun-drenched office in downtown Washington, D.C. "I am now being blamed for things that I didn't do."

Now 82 years old, Mr. Greenspan wants to set the record straight before the ink dries on the first draft of the financial crisis' history. The former Fed chief doesn't deny that he cares about his reputation. But the larger issue at stake, he says, is getting the lessons of the crisis right.

"The [wrong] evaluation of this period -- and how to avoid the problems associated with it -- will give you the wrong answers and the wrong policies," he says.

The Federal Reserve has judged it necessary to take actions that extend to the very edge of its lawful and implied powers, transcending in the process certain long-embedded central banking principles and practices.

As reported by Bloomberg News

What appears to be in substance a direct transfer of mortgage and mortgage-backed securities of questionable pedigree from an investment bank to the Federal Reserve seems to test the time-honored central bank mantra in time of crisis: lend freely at high rates against good collateral; test it to the point of no return.

...

The extension of lending directly to non-banking financial institutions -- while under the authority of nominally `temporary' emergency powers -- will surely be interpreted as an implied promise of similar action in times of future turmoil.

As reported by Bloomberg News

Simply stated, the bright new financial system, for all its talented participants, for all its rich rewards, has failed the test of the marketplace. To meet the challenge, the Federal Reserve has judged it necessary to take actions that extend to the very edge of its lawful and implied powers, transcending in the process certain long embedded central banking principles and practices.

My basic point is that a process of deleveraging, in which many financial intermediaries are simultaneously trying to shrink the size of their balance sheets, has produced a situation in which the quantity of credit available in the overall economy from a wide range of intermediaries has contracted sharply and suddenly—a credit crunch. Moreover, concerns about credit quality and solvency for intermediaries can devolve into liquidity problems, as in an old-fashioned bank run. Firms in the shadow banking sector are particularly vulnerable to this because, like banks, they typically issue short-term, highly liquid debt. The fear that an institution may be unable to meet its obligations to its creditors may trigger a withdrawal of credit—as in a bank run. Of course, the perceived inability of one institution to meet its obligations is likely to cast doubt on the ability of others to meet theirs, triggering chains of distress and systemic risk.

The Federal Reserve was created precisely to stem such systemic risks by acting as a lender of last resort, although not since the Great Depression has the Fed acted to accomplish it by lending directly through its discount window to an entity other than a depository institution. Had the Fed not intervened, however, Bear Stearns would have been unable to meet the demands of the counterparties in its repurchase agreements, and thus intended to file for bankruptcy. Doing so might well have led to widespread fears in the financial markets,

Asset price declines—triggered by concern about the outlook for economic performance—led to a reduction in the willingness to bear risk and to margin calls. Borrowers needed to sell assets to meet the calls; some highly leveraged firms were unable to meet their obligations and their counterparties responded by liquidating the collateral they held. This put downward pressure on asset prices and increased price volatility. Dealers raised margins further to compensate for heightened volatility and reduced liquidity. This, in turn, put more pressure on other leveraged investors. A self-reinforcing downward spiral of higher haircuts forced sales, lower prices, higher volatility and still lower prices.

This dynamic poses a number of risks to the functioning of the financial system. It reduces the effectiveness of monetary policy, as the widening in spreads and risk premia worked to offset part of the reduction in the fed funds rate. Contagion spreads, transmitting waves of distress to other markets ...

The most important risk is systemic: if this dynamic continues unabated, the result would be a greater probability of widespread insolvencies, severe and protracted damage to the financial system and, ultimately, to the economy as a whole. This is not theoretical risk, and it is not something that the market can solve on its own. It carries the risk of significant damage to economic activity. Absent a forceful policy response, the consequences would be lower incomes for working families, higher borrowing costs for housing, education, and the expenses of everyday life, lower value of retirement savings and rising unemployment.

The financial crisis, I think, is the unwinding of what was an excessive credit boom in the years up through middle of last year.  For a variety of reasons global interest rates were quite low, and that generated strong efforts to reach for yield, as it was said, and so there was a lot of risk taking. There was a lot of financial innovation. And the result I think was some unsustainable investment, some unsustainable asset creation.

We've seen the unwinding of that. That is in some ways positive. But on the other hand, the contraction of credit and the restriction of financing that we've seen associated with that has slowed the economy and has had adverse effects on families, as you indicate.    We are trying to find a financial stability. The Fed is working as best we can to stabilize the economy and to stabilize the financial system.

From the Q&A session

With respect to small business, I've heard mixed anecdotes about small business. Not all small community banks have had problems. Many of them were not involved in any way in the subprime lending, for example, and they haven't taken any losses, and so many of them are still making loans to local businesses.

But as a general matter, the loss of capital in the banking system, which has only been partially replenished; the increase in the size of the balance sheets as they brought off-balance-sheet assets onto their balance sheets; and their concerns about liquidity all are creating a situation where our financial institutions are hunkered down. They're not making loans at the normal rate.  And it's having real effects on small businesses, on mortgages, on all aspects of our economy.

From the Q&A session

The line that separates restoring market function from merely redistributing losses and gains is not a bright one. This is the reason that policymakers only rarely and reluctantly intervene in markets.

Also, the distinction between liquidity problems and insolvency is not a trivial one when monetary authorities respond to troubles of market players. The critical evaluation is the systemic risk posed by the failure of an institution.

Some believe the Fed has overreacted. Others have said the central bank has been slow to respond to building problems. And still others have warned that the Fed has crossed lines that define appropriate function.

But from where I stand, Fed actions were taken with a prudent acknowledgement of the unintended consequences that may accompany almost all policy interventions.

The question is, do we need to have the same amount of information about their conditions.

From audience Q&A as reported by Market News International, referring to non-bank primary dealers now that they have access to Fed emergency lending facilities.

The priority focus should be figuring out new ways to enhance liquidity, reduce the fear that people have as counter-party risk
...
We recently opened up our window to lend to what are called primary dealers. I fully expect that in return for that we will get regulatory authority to actually oversee those dealers, to make sure the people we're lending money to are adhering to the principles of good financial behavior.

As reported by Reuters

Together these policy actions expand our role by providing liquidity in exchange for sound but less liquid securities. These policy innovations share important features of increasing both the term and the quantity of our lending and making additional quantities of highly liquid Treasury securities available to financial intermediaries. This is intended to reduce uncertainty among financial institutions and allow them to meet the liquidity needs of their clients.

While these policy actions represent major innovations in practice, they are in the spirit of the oldest traditions of central banking. As described by Walter Bagehot in his 1873 treatise Lombard Street, the job of the central bank is to "lend freely, against good collateral" whenever there is a shortage of liquidity in markets.

I think I would be a fool not to say that when we get through this and when this mess is cleaned up, I'll have to think about what we went through.

From Q&A as reported by Market News International, on the relationship between monetary policy and asset prices.

I think it is naive to think that creditors will view their investments in the largest financial institutions as truly at risk. Consequently, I do not think that increased market discipline is likely to be the panacea that some believe.