American International Group (AIG), America's largest insurance company, has taken a prominent role in the bailout saga. First, it was taken under Federal conservatorship September 17th with an $85B advance for capital—with the intention that the profitable parts of the company would be sold off for as much and repaid to the Fed. Once the bailout money was received, the execs partied with expensive spas and hunting trips. Now AIG is back in the news needing even more bailout money, to the tune of $150B all told.
AIGs role in this was to sell Credit Default Obligations (CDOs), which allowed banks to sell off subprime mortgage backed securities to private investors, giving them more money to lend out, allowing for the ridiculous explosion of credit in the early half of this decade. When pools of mortgages are chopped up in to tranches and sold as securities, banks have to keep the riskiest "unrated" tranches for themselves—the ones that will go belly up first. They can avoid risk by getting CDOs (or bond insurance) on those tranches in case they default. This all is fine and dandy, until the insurance company is teetering on the verge of bankruptcy. Apparently, AIG was a major provider of CDOs.
CDOs are key. So long as banks can insure their unrated tranches as they sell off loans as securitized debt, they are no longer limited by fractional reserves as to the amount of credit they can create. Without CDOs, this credit explosion either could not have happened, or would not have happened to the degree that it did. Bailing out AIG is a more civil way of handing money to banks straight up.