Insolvency vs. Illiquidity in the 2008 Crisis and the Congressional Imagination

Crisi Finanziaria e Riposte Normative: Verso Un Nuovo Diritto Dell'Economica? (2014, Milano, Quaderni di Giurisprudenza Commerciale, Guiffre)

Fordham Law Legal Studies Research Paper No. 2392914

24 Pages Posted: 9 Feb 2014 Last revised: 15 May 2014

See all articles by Richard Squire

Richard Squire

Fordham University School of Law

Date Written: February 8, 2014

Abstract

What can we learn from the fact that, in the end, Wall Street paid back all of its bailout money, with interest? We now can see that the crisis of 2008 was a rolling loss of investor confidence in financial firms whose solvency was threatened by an ongoing decline in house prices. When investors lost confidence in a firm, it could no longer raise cash to fulfill its immediate obligations. As it turned out, the stabilization of house prices in 2009 meant that most of the firms were never insolvent. Even in 2008, the present value of their future operating profits exceeded their liabilities. Therefore, the federal government was able to keep the firms out of bankruptcy without losing money along the way. The exception is Lehman Brothers, which was not bailed out and does seem to have been insolvent.

This account of the crisis suggests that a regulatory statute designed to prevent a replay of 2008 would have two primary objectives: prevent housing bubbles, and reduce the risk to financial firms from liquidity shortages. Remarkably, Dodd-Frank, in its essentials, pursues neither of these goals. Very few of its provisions address the housing market, and those that do have little relationship to the threats posed by bubbles. Instead, the statute treats interconnectedness as the main threat to system-wide stability, thus misdiagnosing the contagion of 2008. The ostensible problems that Dodd-Frank addresses bear little relation to the crisis that prompted Congress to enact it.

Keywords: systemic risk, Dodd-Frank, financial crisis, banking regulation, liquidity

Suggested Citation

Squire, Richard C., Insolvency vs. Illiquidity in the 2008 Crisis and the Congressional Imagination (February 8, 2014). Crisi Finanziaria e Riposte Normative: Verso Un Nuovo Diritto Dell'Economica? (2014, Milano, Quaderni di Giurisprudenza Commerciale, Guiffre); Fordham Law Legal Studies Research Paper No. 2392914. Available at SSRN: https://ssrn.com/abstract=2392914

Richard C. Squire (Contact Author)

Fordham University School of Law ( email )

150 West 62nd Street
New York, NY 10023
United States
212-964-1584 (Phone)

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