What we now know

First, the righteous glee with which Barney Frank, Chris Dodd, Chuck Schumer, Larry Summers and even our president took to the microphones to denounce AIG for handing out contractually obligated bonuses, blame Republicans for not placing restrictions on bailout money, and toughly promise to get that money back by hook or by crook was sweaty and a bit disgusting. I don't like Democrats standing on principle when it's cheap and using the politics of fear when it's not. None of them will talk about undoing Gramm-Leach-Bliley, or amending the bankruptcy laws so an automatic stay applies to derivatives contracts. That would require testicular fortitude, in very short supply on the left side of the aisle. By avoiding nationalization of AIG, this administration and THIS majority party are forcing American taxpayers to continue bailing out foreign banks, sovereign wealth funds and american financial institutions that are now double-dipping in the public trough.
So, here's what we now know:
High on the list of AIG's CDS counterparties are Goldman-Sachs, Citi, B of A, Merrill, Morgan Stanley, Wachovia and, oh look, Citadel. Nice to see they made it on the list.
Starting in late 2004 or early 2005, they all became terrified that the housing bubble, propping up the assets contained in the securities bundles out of which the exotic bond instruments they invented and gorged themselves on, would certainly collapse, and that some form of insurance was essential. They all suddenly gorged themselves on AIG CDS products to massively hedge the risk of their CDO portfolios. In 2004, the CDS market was insignificantly small, relative to other derivatives markets. The 2005 bankruptcy bill explicitly named CDS contracts as exempt from automatic stays in bankruptcy proceedings. The game was on, the risk-free hedge was now possible. By mid-2008, OTC CDS had exponentially exploded to over $60 trillion in notional contracts.
What AIG just confirmed is that all these major financial institutions knew, as far back as 2005, that they had created a house of cards destined to collapse.