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.