That is the title of a new NBER working paper by Robert McDonald and Anna Paulson (ungated versions). They conclude,
Much of the discussion about the crisis has focused on liquidity versus solvency. The two cannot always be disentangled, but an examination of the performance of AIG’s underlying real estate securities indicates that AIG’s problems were not purely about liquidity. The assets represented in both Maiden Lane vehicles have experienced write-downs that disprove the claim that they are money-good. While it may seem obvious with the benefit of hindsight that not all of these securities would make their scheduled interest and principal payments in every state of the world, the belief that they could not suffer solvency problems and that any price decline would be temporary and due to illiquidity was an important factor in their creation and purchase.
My random comments:
1. This is valuable work. I am really glad to see a retrospective audit of this important bailout.
2. I view the conclusion as saying that this truly was a bailout. The Fed was not acting as a hedge fund of last resort, buying temporarily undervalued assets that otherwise were just fine.
3. This also throws Gary Gorton under the bus. Gorton said that AIG’s problems were collateral calls, meaning illiquidity rather than insolvency. Note that Gorton is not included in the list of references, at least in the ungated version. Note also that the authors write that AIG’s problems were both liquidity and solvency.
4. Bob McDonald and I shared an apartment our first year as MIT grad students. He has written a treatise on derivatives.
As they say, they can’t be disentangled. What if Lehman had gotten an even-handed treatment?
Are certain patterns of trade dependent on collective fictions? Maybe if fewer people had been burned by the previous pattern it may not have settled into such a low steady state level.
I’m glad to see another paper on this topic. This paper: http://onlinelibrary.wiley.com/doi/10.1111/fima.12056/abstract does the important job of attempting to disentangle solvency from liquidity. The use banking data from a variety of crises over the past few decades, not just the most recent one, to show that solvency problems are much more important than liquidity problems. That certainly has implications for how crises should be managed.
Just to play Satan’s Lawyer on the internet, “In particular, we examine the
write-downs on the assets in these portfolios from each asset’s inception
to October, 2014” say the authors, but you could argue that the downturn since 2008 by its very nature turned a minor problem of illiquidity into one of insolvency (they said the same thing about the Great Depression and the Crash of 1929). You could say this particularly if you are a Keynesian, who believes any temporary absence of demand always turns bad into worse.
Who needs Satan’s lawyer when the 4th paragraph of the referenced article says this:
“An issue central to any discussion of AIG is the question of whether the firm’s difficulties stemmed from illiquidity or insolvency. The term “illiquidity” is imprecise, but at a minimum means that assets cannot be quickly sold at fair value and is often meant to refer to a price decline that is temporary. “Insolvency” usually means that the fair value of a firm’s assets is less than the par value of liabilities. Illiquidity and insolvency are linked: A FIRM THAT CAN SELL ASSETS ONLY AT A STEEP DISCOUNT TO FAIR VALUE MAY BE INSOLVENT AS A CONSEQUENCE. We make no attempt to assess AIG’s overall solvency, but we do consider whether AIG’s real estate positions incurred permanent losses.”
The portfolio was forced to buy out its counterparties before values recovered, building in the losses. AIG was a bailout of the European banking system not a bailout of AIG.