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

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