This is lazy blogging on my part, but The Anonymous Liberal's explanation of AIG's role in our troubled economy is as good a primer as it gets:
Imagine, for a moment, that there was a company that offered stock market insurance. For a small premium–pennies on the dollar–you could buy an insurance policy that compensated you in the event your stock investments lost money. If there were such a company, what would you do? You'd buy a whole lot of stock, of course, and a corresponding insurance policy to hedge your bets. It would be a no-brainer, a low-risk, high-reward investment strategy.
In fact, because you were exposed to so little apparent risk, you'd probably leverage up big time. You'd borrow as much money as you could and you'd buy stock with it (along with corresponding insurance policies). Why not? Your investment gains would be more than enough to cover the interest on your loan. You'd be making money off other people's money.
And everyone else would be too. The ability to cheaply hedge against loss would encourage everyone to buy massive amounts of stock, with borrowed money. With everyone's money pouring into the stock market, stock prices would rise at a brisk and steady pace, seemingly validating everyone's investment strategy. A massive stock market bubble would soon form, but for a while, everyone would make lots of money. The investors would make money. The folks loaning them money would make money. And the insurance company would make lots of money from the premiums it was collecting.
But at some point, people would realize that stocks were greatly overvalued. The bubble would burst and the market would come crashing down. And the insurance company would suddenly owe unfathomable sums of money (much more than it could possibly pay) to everyone who had purchased its stock market insurance policies.
That, in a nutshell, is the story of AIG, except of course that AIG was insuring a different type of investment. AIG was in the business of issuing credit default swaps, which are essentially insurance policies that protect lenders from defaults by borrowers. The availability of cheap credit default swaps turned mortgages into a seemingly risk free investment. Mortgages and mortgage-backed securities paid steady, consistent returns and any downside risk could be effectively hedged by buying AIG's credit default swaps. So demand for mortgage-backed securities shot through the roof. Investment banks couldn't get enough of them. In order to fill the demand, banks and mortgage companies started issuing mortgages to anyone and everyone one who wanted one, even if they had terrible credit. New fly-by-night lenders and new kinds of mortgages suddenly appeared on the scene. They offered no-down payment loans and teaser rates. Anything to get people to sign on the dotted line. The mortgage issuers would then turn around and immediately sell them to investors, thereby insulating themselves from any default risk. As the market flooded with easy credit, housing prices rose at a brisk pace. The steady rise in value encouraged people to take out even bigger loans and to borrow against their apparent equity. The lenders were happy to oblige because the market for mortgages was so strong. The investors kept buying because they were getting steady returns and were insured against loss. The returns were so steady, in fact, that they saw an opportunity to leverage and began buying mortgage securities with borrowed money.
A huge asset bubble was created. Eventually it became so obvious that a bubble existed that savvy investors started buying credit default swaps not as a hedge, but simply because they knew everything was about to come crashing down. And AIG was happy to issue them.
Then the bubble burst. Now AIG is on the hook for all of the ridiculous policies it underwrote. And there's no way it can possibly pay them all off.
I don't mean to imply that this is all AIG's fault. There's a lot of blame to go around, and there were other companies that were in the credit default swap business. But AIG was the worst offender and it played a critical role in creating this fiasco. Without a big company willing to write these insane insurance policies, the situation never would have gotten as out of control as it eventually did. Investors made horrible bets on mortgages and mortgage-backed securities, but they were encouraged to do so by the availability of an easy hedging mechanism, i.e., cheap credit default swaps that AIG issued by the billions without ever considering what would actually happen if home owners began defaulting on their mortgages in large numbers. AIG was as reckless as a company can possibly be.