Joe Nocera does a good job of explaining how AIG is ground zero of the economic melt down. Essentially, it was a linchpin in the process of concentrating and magnifying the risk from questionable mortgage practices.

Step one – a potential homeowner maybe with or without a reasonable expectation of paying a mortgage based on varying levels of information buys a mortgage. The broker and lender take their commission and sell it on up the line; taking the money & running.

Step two – the mortgages get aggregated and sold as a security.

Step three – AIG steps in and sells credit default swaps for these securities. Basically, this is a form of magic dust sprinkled over the mortgage-backed securities to make them look safer than they are. AIG has a AAA rating. It sells these credit default swaps as a form of insurance for the mortgage-backed securities, converting these securities from their natural level of risk to a AAA rated security, ostensibly risk free or close to it.

Why would Wall Street and the banks go for this? Because it shifted the risk of default from themselves to A.I.G., and the AAA rating made the securities much easier to market. What was in it for A.I.G.? Lucrative fees, naturally. But it also saw the fees as risk-free money; surely it would never have to actually pay up. Like everyone else on Wall Street, A.I.G. operated on the belief that the underlying assets — housing — could only go up in price.

That foolhardy belief, in turn, led A.I.G. to commit several other stupid mistakes. 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.

In addition, AIG took extra money for inserting “collateral triggers” into its derivative contracts, meaning that if its rating declined (and by extension the rating of the mortgage securities it was insuring), it had to put up collateral. The credit default swaps let purchasing banks make their own balance sheets look less risky than they really were. Because they weren’t properly accounting for actual risk, these banks were allowed to advance loans without adequate capital.

So, if we let AIG go belly up, then all of that risk transferred to AIG through the magic of credit default swaps suddenly reappears on the bank’s balance sheets, triggering capital requirements for the banks, resulting in a huge crater where our banking system used to be.

Here’s what is most infuriating: Here we are now, fully aware of how these scams worked. Yet for all practical purposes, the government has to keep them going. Indeed, that may be the single most important reason it can’t let A.I.G. fail. If the company defaulted, hundreds of billions of dollars’ worth of credit-default swaps would “blow up,” and all those European banks whose toxic assets are supposedly insured by A.I.G. would suddenly be sitting on immense losses. Their already shaky capital structures would be destroyed. A.I.G. helped create the illusion of regulatory capital with its swaps, and now the government has to actually back up those contracts with taxpayer money to keep the banks from collapsing. It would be funny if it weren’t so awful.