If you want to understand why we’re throwing another $30 billion at AIG, you really need to read this story in the Times (Desperately Protecting A.I.G.’s House of Cards) which renders the incomprehensible business of credit default swaps remarkably clear:
When a company insures against, say, floods or earthquakes, it has to put money in reserve in case a flood happens. That’s why, as a rule, insurance companies are usually overcapitalized, with low debt ratios. But because credit-default swaps were not regulated, and were not even categorized as a traditional insurance product, A.I.G. didn’t have to put anything aside for losses. And it didn’t. Its leverage was more akin to an investment bank than an insurance company. So when housing prices started falling, and losses started piling up, it had no way to pay them off. Not understanding the real risk, the company grievously mispriced it.