Joe Nocera, NY Times - 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 (i.e. risky mortgages) off their books through "insurance," therefore allowing them to leverage themselves even more. And AIG effectively bought the risk (i.e. 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.
David Sirota, Open Left - This is why AIG is called too big to fail: because if it simply defaults on its obligations, it will destroy all of the investments [and] assets it was purporting to insure. And there is just a massive amount of those all throughout the economy. . . Any institution that is allowed to become so foundational to the whole economy should be at least partially nationalized - not temporarily, but permanently. AIG is about the best example of this.