The financial collapse of AIG wasn’t an accident. The conditions were just right for individuals of every walk of life to make a killing on the way the financial system reacted to the real estate boom. The basic mistake was the misallocation of resources. The world didn’t need all of this new housing, but it was very profitable to build and finance. The increased property values implied that the banks couldn’t lose on any loan. The tax base increased proportionally and government expanded (exploded). It was only "short bus" math to figure out that over 30 years, a person earning $35,000 per year was not going to have the resources to pay off, a 30 year, one million dollar mortgage.
All of a sudden it stopped, the bubble burst. AIG and several hedge funds collapsed. The side bets (derivatives/insurance/credit-default swaps) covering those exposed to loss came to the surface. These hedge funds were writing insurance on everything including the kitchen sink.
Risk had been removed from the business model. It’s hard to lose money if you place the right side bets (that’s without even including Fannie and Freddie in this mess). Too much “insurance coverage” had been written. The insurance premiums were collected and went into someone’s pocket. The estimated 40 to 80 trillion of derivatives written to insure against financial loss will never be paid.
For example, Greek bonds have a substantial risk, but buy insurance and your worries are gone. If you are the Greek government, buy the insurance (you can’t lose). If you work for the Greek government, why buy the bonds? Just buy the insurance and when Greece goes belly up, retire to the good life. Greece will make that glaringly apparent when they collapse (after receiving their bail out money).
The real fault with this "insurance" is that you don’t have to have a relationship to the asset being insured. There is nothing to stop you from insuring your neighbor’s home and then burning it down. Plus if the neighborhood has "a gut feeling about that house," there’s going to be several policies written on that home. Then when the expected happens, (it burns to the ground) everyone gets rich. It’s as if, AIG was the insurer for anyone placing a bet on that house. Geithner and Bernanke saved the day; everyone got paid on that one.
Three questions arise. Were the insurance rates too low for the coverage written? Should the contracts have been allowed to be written in the first place? Shouldn’t you have to prove your vested interest in the insured, in order to purchase the product?
The Panic of 1907 led to legislation that made this sort of "insurance" illegal; the bucket shops which sold it, were banned in 1909. And then 91 years later, Congress rolled that law back. We were smarter now and knew what we were doing. Just as a our person making $35,000 a year can't pay off that million dollar loan, the 50 trillion dollars in risk arbitrage can't be paid either. The risk in the market is real, the "insurance" isn't. And, as in all fairy tales, everyone lives happily ever after.