AIG, credit default swaps, making gambling legal and making gamblers whole

Here is a lucid commentary on what happened to AIG and why bailing it out is not sensible. He explains that AIG has been essentially two companies: one an insurance company that is well-regulated and well-run and profitable, and one that has been a player in the highly risky, unregulated world of derivatives. It's the losses of the second, risky company that we're bailing out which is all wrong because everyone playing in that game should have been aware of their risks and should bear their own losses.

The NYT today, in its editorial, echos this assessment (and goes on to demand answers to some good questions).

Still, [AIG's] trading partners knew, or should have known, how dangerous the swaps were. And that is not necessarily the whole story. In the manic years of this decade, credit default swaps took off as a way to bet on the likelihood of default by a firm or an investment portfolio, without having to own any financial interest in the firm or portfolio. That is definitely not insurance, it is gambling. The reason it is not illegal gambling is that, in 2000, Congress specifically exempted credit default swaps from state gaming laws.

The Commodity Futures Modernization Act of 2000 (that exempted credit default swaps from prosecution under state gaming laws) passed on the last day and last vote of the 106th Congress. Republicans controlled both the House and the Senate and was introduced by Republicans (Rep. Thomas Ewing and Senator Dick Lugar), but the bill had bipartisan sponsorship, passed with bipartisan support and passed unanimously in the Senate and was signed by Pres. Bill Clinton. (Steve Kroft did a piece on 60 Minutes about credit default swaps that aired in October 2008.)