For those of you trying to sort out what's behind the AIG implosion, the answer is a derivative contract called a collateralized Debt Swap (CDS). These contracts are used to transfer the risk of default on debt (bonds and other debt-based securities) to other parties. There's a good graphic explaining how they work here, courtesy of The New York Times.
The problem for AIG is their exposure to these instruments. As an insurer, they were involved in a lot of these contracts to help other firms hedge against loss. But the value of the underlying contracts (mortgages in many cases) was uncertain. This is leaving AIG exposed to a lot of claims as contracts go into default. When that happens, AIG makes a payment. Consequently, with the number of default payments they've had to make, AIG is short capital.
There's more to come on this, but in the interim, I will point you to two other resources that may help you as the smoke clears. The first is a YouTube video that features an interview with Princeton economics professor and former Federal Reserve vice-chairman, Alan Blinder. (HT to Greg Mankiw.)
The other is the blog by Professor William Polley at Western Illinois University. I met Dr. Polley when I was in Chicago and he writes one of the best Fed watching blogs for educators. I always appreciate his insights.
I look forward to your insights, as well.