Volcano Insurance

Let's say you live next to a volcano. Let's also say you run an insurance company. You make all sorts of bet with all sorts of people, collecting premiums. You do well. Then one day you come up with a way to make huge profits: you'll sell volcano insurance. After all, the volcano hasn't erupted in ages. This is money for nothing - right?

Fast forward three years. The volcano erupts. You're on the hook for hundreds of billions in insurance policies you have no way of paying. And your clients will go bankrupt themselves if you don't pay them. In this case, you're AIG, the volcano insurance was CDS, and your clients were major US and European banks. Now you go hat in hand to the government, telling the Feds that if they don't bail you out, the world will end. From Bloomberg:

What happens to AIG has the potential to trigger a cascading set of further failures which cannot be stopped except by extraordinary means. Insurance is the oxygen of the free enterprise system. Without the promise of protection against life's adversities, the fundamentals of capitalism are undermined.

This is extortion. And what is the point of indirectly bailing out AIG's counterparties? Why not do so explicitly? Many of them are European banks, and we would certainly stop bailing them out. As for the American banks, if they are so desperate for capital that taking a hit on their payout from AIG would push them into insolvency, then they should probably be in some form of government receivership. AIG should go through an orderly bankruptcy where creditors agree to write down debts to some levels to make a continuing bailout at least a little cheaper. The taxpayers should not simply pump money into the system to make Goldman whole.