Why AIG Is So Central to the Meltdown

It can be difficult to figure out what caused the financial meltdown -- there's lots of esoteric terms being thrown around. That's why I want to flag this excerpt from the New York Times, because it really explains AIG's role in all of this:

These exotic instruments [that AIG sold] acted as a form of insurance for the securities. In effect, AIG was saying that if, by some remote chance (ha!) those mortgage-backed securities suffered losses, the company would be on the hook for the losses.

Why would Wall Street and the banks go for this? Because it shifted the risk of default from themselves to AIG...What was in it for AIG? Lucrative fees, naturally. But it also saw the fees as risk-free money; surely it would never have to actually pay up...

A huge part of the company's credit default swap business was designed, quite simply, to allow banks to make their balance sheets look safer than they actually were...The less risky the assets, obviously, the lower the regulatory capital requirement. How did banks get their risk measures low? Why, they bought AIG's credit default swaps, of course! The swaps meant that the risk of loss was transferred to AIG...which meant minimal capital requirements, which the banks all wanted so they could increase their leverage and buy yet more "risk-free" assets.

So, in other words, AIG served as a way for banks to appear to take the risks of their most risky investments (ie. risky mortgages) off their books through "insurance," therefore allowing them to leverage themselves even more. And AIG effectively bought the risk (ie. insured it against loss), believing that the housing bubble would never burst and thus that it would never have to pay out insurance benefits on losses.