Shooting the moon

AIG is an insurance company, except instead of insuring cars or houses or someone's healthcare, it insures people who lend money. For example, say I want to lend money to Joe. There is a small probability that, for whatever reason, Joe won't be able to pay me back. But I want to eliminate the possibility of a disasterous loss. So, for a modest fee, I buy an insurance policy from AIG that says that I will be reimbursed the full amount of the loan in the unlikely event that Joe defaults on my loan. From AIG's perspective, it has essentially placed a bet that Joe will be able to pay off the loan.

The problem is, AIG placed too many bets: it sold more insurance policies than it could deliver on in the event of widespread defaults. In the same way that a bank is screwed if everyone decides to withdraw their money at the same time, AIG became screwed because everyone came to them with a claim at the same time. There was a "run" on AIG.

Now, predictably (and rightfully), scorn is being heaped on the executives at AIG. But the Opinionator also brings up this interesting point, which is that financial institutions that took out policies from AIG were also acting poorly:

John Carney at Clusterstock... recommends we...“direct a bit of our righteous anger at the customers of A.I.G., those financial institutions who bought insurance from A.I.G.”

Why? “They are truly accomplices of A.I.G. in the scam.”

Many of them were well aware that AIG couldn’t possibly fund the insurance policies it was writing. But they didn’t worry about that because they were operating under the same assumption AIG was: that the policies would never have to be funded on any widespread scale. Defaults on credit products were supposed to be isolated and non-correlated.

What’s more, many assumed that a complete AIG meltdown was what we call a “Financial Armegeddon” bet. The idea was that AIG would never be allowed to default on its obligations — it would be bailed out by the American taxpayers. And if the American taxpayers couldn’t afford to bail out AIG, well then you’d be in such dire straits that your main concern would be food, shelter and ammo and not the performance of your loan portfolio.

By bailing out AIG, and therefore bailing out its counterparties, the US government is rewarding this kind of reckless behavior. And it is punishing responsible credit insurance writing, essentially telling anyone who placed a premium on buying insurance from a solvent insurer that they were suckers. They should have bought the cheap contract from AIG instead.

Well. If a few people make a Financial Armegeddon bet, that's just fine--but if everyone makes that bet, then, well--you get Financial Armegeddon. But of course, for each individual, making this bet was the rational thing to do--so here we are.

How could anyone have argued for deregulation in this area? Isn't this, like, the canonical scenario where everyone agrees that regulation is required?