The rescue of AIG distorted the marketplace by transforming highly risky derivatives bets into fully guaranteed payment obligations. In the ordinary course of business, the costs of AIG’s inability to meet its derivative obligations would have been borne entirely by AIG’s shareholders and creditors. But rather than sharing the pain among AIG’s creditors, the government instead shifted those costs in full onto taxpayers. The result was the government backed up the entire derivatives market, as if high-profit, high-risk trading deserved the same taxpayer backstop as savings deposits and checking accounts. Every counterparty — from pension funds for retired workers and individual insurance policies, to sophisticated investors and other financial institutions — received exactly the same deal: a complete rescue at taxpayer expense.
That's just one item from the report on the AIG bailout by the Congressional Oversight Panel (the group set up to monitor the TARP). Go read the whole thing.
This phenomenon of government guarantees, both explicit and implicit, is at the heart of how we got ourselves to the brink of disaster in the fall of 2008.
It is a long-running story, perpetuated by members of both political parties across the years. Its effects are incredibly corrosive on the willingness of creditors to enforce discipline, and we are all the poorer for it.