Henry Paulson could afford to apply tough love to Lehman Brothers, the investment company that entered bankruptcy proceedings this week. Lehman's collapse, the treasury secretary knew, would cause limited damage outside midtown Manhattan.
Washington can't be so complacent with American International Group, the latest financial giant suffering from the mortgage crisis. AIG, the world's biggest insurance company, is one of the last firewalls between the mortgage meltdown and the general economy, hence last night's government bailout.
An AIG bankruptcy would bring the housing crisis full circle, back to the neighborhoods where it began. This time it would hurt people who didn't lose their homes.
The company is so big and does business with so many other corporations that a collapse could trigger a nationwide drought in lending, spending and hiring.
Through complex contracts called derivatives, AIG guarantees billions in bonds and other loans from default, including mortgage-backed securities.
AIG is well known for its property, auto and life insurance. The complicated derivatives amount to credit insurance, and they have already cost AIG $25 billion during the past year as it got hit by blowup after mortgage blowup.
Bankruptcy would hinder it from honoring remaining credit guarantees, forcing lenders worldwide to depreciate assets and possibly prompt a fire sale of stocks and bonds.
Ordinary policyholders don't seem to be at great risk from AIG's troubles. Regulations protect insurance company assets from raids by their holding companies.
But AIG's problems could beget further turmoil in the market for the debt insurance contracts. That market was worth $58 trillion worldwide at the end of 2007, according to the Bank for International Settlements.
How much of that $58 trillion is AIG responsible for? Nobody knows. Maybe not even AIG. That's part of the problem. The consequences of an AIG failure are one of the "known unknowns" that Washington regulators probably don't want to be further educated on.
Last week, mounting losses increased the chances that rating agencies would downgrade AIG's debt. That would entitle AIG's lenders to demand billions in new collateral. It turned out AIG didn't have any collateral that wasn't locked up inside its traditional insurance businesses.
Over the weekend, it reportedly talked to several private equity firms about a capital infusion and then sought a $40 billion loan from the Federal Reserve, the nation's central bank. The Fed said no.
Late Monday, AIG was trying to wheedle help from Wall Street investment banks Goldman Sachs and JPMorgan, according to various reports. By then the reported amount requested had gotten even bigger: $75 billion.
Also on Monday, New York Gov. David A. Paterson agreed to let AIG borrow $20 billion from its regulated insurance companies, an extraordinary move that was justified by "the risks if we don't act," Paterson told reporters. Monday night, rating agencies downgraded AIG.
The company is the latest financial behemoth to leave a trail of cooing reassurances from executives that were quickly belied. Late last year, then-CEO Martin Sullivan said mortgage losses would be "manageable."
They weren't manageable for AIG, and an AIG bankruptcy filing wouldn't be manageable for the economy.
The Lehman Brothers filing represents the biggest bankruptcy in history. An AIG bankruptcy would be twice the size of Lehman's. And more than twice as painful.