I just got off of the phone with my father...who is the president of two insurance companies...
I called him up and asked him directly why AIG was bailed out. He told me that he had been fielding calls all day in the same vein but he took the time to explain it to me.
AIG is a conglomerate of insurance companies that heedlessly went into the investment side. Ultimately all of their insurance clients are covered by states and state laws. Their swaps and CDO's got bigger than their reserves. They did make horrible decisions on this, but they need to be saved. 600 insurance companies depend on AIG as a holding company. This is life, estate, annuities...these companies require this umbrella. Most of these are very small. Follow the law. Have more cash in the vault than what they would have to pay out it someone dies.
Investment banks should have never been saved, but if AIG had gone under, there would have been a wave of insurers failing, and after that a wave of bankruptcies, and then a wave of small bankruptcies after that. And who pays for that?
These investment banks deserve their pain and so does AIG at some point, but AIG needs to exist. The Fed made the right decision.