How could one company be worth bailing out for $180 billion? That’s how much the US has contributed to AIG so far.

So what is it about an insurance company that makes AIG so central to the financial system that they can’t be allowed to fail at any cost?

Hank Paulson used to at least make a show of trying to explain the latest bailout moves. It seems that the Obama administration, despite all that talk about transparency, has just decided to keep Tim Geithner locked up on these critical days.



But let's light a match rather than curse the darkness. To understand why AIG is special, you need to understand how credit default swaps wound up playing an important role on the balance sheets of banks all around the world. Basically, as banks loaded up on risky corporate loans and mortgage backed securities, they were forced with a choice: sock away more money against a rainy day or buy an umbrella from AIG. If you bought the umbrella, you were allowed to keep using your capital for investments.



Now that it’s rained for something like 400 days, it’s all too clear that AIG didn’t have enough umbrellas to go around.



Let’s drop the metaphor. Banks all around the world never fully-accounted for the losses they would have to take if their loans stopped paying off at expected rates because they had bought insurance against these losses from AIG. If the banks had to account for those likely losses, they would have to start socking money away. This is what regulators are trying to prevent by bailing out AIG.



Why should we help banks avoid meeting the reserve requirements? The answer the regulators would probably give—if they hadn’t decided to just stop telling us what they were doing—is that this would cause the economy to freeze up.



Sellers. Some banks would try to meet their reserve requirements by selling off-balance sheet assets. Those assets, however, are already trading at a steeply discounted rate. Banks would have to take steep losses, and the flood of assets into the market place would make those losses even more extreme. Some banks would not survive the hit.



Savers. Other banks would attempt to meet reserve requirements by dramatically scaling back their lending activity. As depositors are increasing their savings, it is fairly easy for a healthy-ish bank to raise the reserve levels by simply lending out a smaller out. More money coming in, less going out. Regulators fear this would starve the markets of credit.



So, yes, it’s still the same story. We’re trying to save the economy and prop up banks so that they will continue to lend and not fail outright. We’re doing that by making sure banks don’t have to take the losses they bought insurance against from AIG. Instead, taxpayers will take that loss.