And Another One Bites the Dust

A really bad weekend was punctuated by the federal buyout last night of American International Group, the world's largest insurance company. Our federal government injected $85 billion of cash in return for warrants that, if exercised, would allow the feds to take a 79.9 percent stake in the company.
You may have thought that insurance was a pretty boring business, and AIG's auto and home insurance businesses are said to be doing fine. The product line that brought the company down involved—you guessed it—mortgages. The New York Times explains:

What frightened Fed and Treasury officials was not simply the prospect of another giant corporate bankruptcy, but A.I.G.’s role as an enormous provider of esoteric financial insurance contracts to investors who bought complex debt securities. They effectively required A.I.G. to cover losses suffered by the buyers in the event the securities defaulted. It meant A.I.G. was potentially on the hook for billions of dollars’ worth of risky
securities that were once considered safe.
If A.I.G. had collapsed — and been unable to pay all of its insurance claims — institutional investors around the world would have been instantly forced to reappraise the value of those securities, and that in turn would have reduced their own capital and the value of their own debt.

AIG has $440 billion of insurance outstanding on mortgage backed securities. Had AIG failed, the world's largest financial institutions would have been forced to write down the value of these securities on their balance sheets, accelerating the financial crisis.