The Un-doing of AIG

AIG was a global insurance giant that came crashing down two weeks ago, precipitating the Credit Crisis and launching the $700 billion rescue plan. Here's an article that explains what happened. Here's the outline:

• It all started with Credit Default Swaps or CDSs. When you lend money to somebody, you naturally want to protect yourself from loss in case the borrower defaults on the loan. CDSs are basically the same idea, only extended to much bigger companies. This primer from PIMCO explains the process.
• Pension funds and banks and other institutions around the world wanted to invest in the CDOs and CMOs created by Wall Street investment firms. But they also needed to protect themselves.
• That is where AIG came in. AIG created CDSs for all these institutions promising them to pay up if the CDOs defaulted. The only problem? This was all done completely off-the-books. AIG either chose deliberately not to handle this as a legitimate insurance product (following due process such as setting aside reserves for losses etc.) or they just plain did not know how (CDSs being a new product).
• In either case, once CDOs default wave started, AIG ran out of capital very quickly. Now they were entangled in this giant global web that would unravel and cause a global crisis. This is when US Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke recognized the depth of the problem and stepped in and provided AIG capital in return for part ownership.