The Institutional Risk Analyst has put together a great article on how AIG got into the Credit Default Swap business.
Basically, AIG, Gen Re and others used reinsurance to fraudulently transfer Liability from ceding companies (lowering the ceding company’s reserve requirements, increasing the ceding company’s capital, etc) by using “side letters” which absolved AIG from actually paying on any losses it reinsured.
“It was easy for AIG to become addicted to the use of side letters. The firm, which had already encountered serious financial problems in 2000-2001, reportedly saw the side letters as a way to mint free money and thereby help the insurer to look stronger than it really was. AIG not only helped banks and other companies distort and obfuscate their financial condition, but AIG was supplementing its income by writing more and more of these reinsurance deals and mitigating their perceived exposure via side letters.”
When the AIG managers realized “that state insurance regulators and the FBI where on to the reinsurance/side letter scam”, AIG moved the reinsurance/side letters model to create Credit Default Swaps (CDS) for finance firms; unregulated “insurance” for securities of derivatives and sub-prime mortgages.
The article concludes that AIG received bailout funds illegally from the Fed and Treasury, because AIG then gave those funds to counter-parties like Goldman Sachs to make them whole on losses that were a result of illegal AIG CDS contracts.