AIG used credit default swaps to insure the high yielding, subprime mortgages that the banks invested in to get to their profits up. The Basel II rules determine how much capital a bank must have, based on the quality of the bank's loan book - the riskier the loans, the more capital and therefore the less gearing that can be employed.
AIG offered a way around this for a fee, and it was able to do so because its vehicle AIG FP in London was unregulated as an internal finance function (yeah right!), so that no capital at all was required on the swaps. AIG had a AAA credit rating, which was effectively bestowed on the subprime mortgages by the CDS insurance.
Banks were able to tell their regulators that high yielding subprime mortgages were actually AAA assets requiring minimal capital under Basel II, even though AIG was insuring them using no capital itself.
Better still, using mark-to-market accounting, AIG could book a one time profit from the fees on a five year CDS as soon as it was written, subtracting the expected losses from defaults from the up front fee. In other words, whatever a computer said AIG was likely to make on a contract, the accountants could book as immediate, actual profit, and the broker that sold the contract could be paid an immediate bonus.
The FBI is investigating AIG, Fannie Mae, Freddie Mac and Lehmans, and has 1,500 other mortgage-related investigations underway.
State agencies are also busy with mortgage fraud cases and the State of California is suing the mortgage originator, Countrywide Financial, for deception and "unfair competition".
This weekend the US President George W Bush concluded his radio address with these words: "America is the best place in the world to start and run a business, the most attractive destination for investors around the globe, and home to the most talented, enterprising, and creative workers in the world. We're a country where all people have the freedom to realise their potential and chase their dreams. This promise has defined our nation since its founding, this promise will guide us through the challenges we face today, and this promise will continue to define our nation for generations to come."
And some time soon some of the most talented, enterprising and creative workers will be behind bars.