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KEITH HENNESSEY, DOUGLAS HOLTZ-EAKIN, AND BILL THOMAS 

these funding markets would always be healthy and functioning smoothly. By
failing to provide sufficiently for disruptions in their short-term financing,
management put their firm’s survival on a hair trigger.
• Poor risk management systems. A number of firms were unable to easily ag-
gregate their housing risks across various business lines. Once the market be-
gan to decline, those firms that understood their total exposure were able to
effectively sell or hedge their risk before the market turned down too far. Those
that didn’t were stuck with toxic assets in a disintegrating market.

Solvency failure versus liquidity failure

The Commission heard testimony from the former heads of Bear Stearns, Lehman,
Citigroup, and AIG, among others. A common theme pervaded the testimony of
these witnesses:

• We were solvent before the liquidity run started.
• Someone (unnamed) spread bad information and started an unjustified liquid-
ity run.
• Had that unjustified liquidity run not happened, given enough time we would
have recovered and returned to a position of strength.
• Therefore, the firm failed because we ran out of time, and it’s not my fault.

In each case, experts and regulators contested the former CEO’s “we were solvent”
claim. Technical issues make it difficult to prove otherwise, especially because the an-
swer depends on when solvency is measured. After a few days of selling assets at fire-
sale prices during a liquidity run, a highly leveraged firm’s balance sheet will look
measurably worse. In each case, whether or not the firm was technically solvent, the
evidence strongly supports the claim that those pulling back from doing business
with the firm were not irrational. In each of the cases we examined, there were huge
financial losses that at a minimum placed the firm’s solvency in serious doubt.
Interestingly, in each case, the CEO was willing to admit that he had poorly man-
aged his firm’s liquidity risk, but unwilling to admit that his firm was insolvent or
nearly so. In each case the CEO’s claims were highly unpersuasive. These firm man-
agers knew or should have known that they were risking the solvency and therefore
the survival of their firms.

Conclusions:
• Managers of many large and midsize financial institutions in the United States
and Europe amassed enormous concentrations of highly correlated housing
risk on their balance sheets. In doing so they turned a building housing crisis
into a subsequent crisis of failing financial institutions. Some did this know-
ingly; others, unknowingly.
• Managers of the largest financial firms further amplified these big bad bets by