Just a little over nine years since the the federal government gave the American International Group Inc. — better known as AIG (NYSE:AIG) — a bailout of $85 billion, the U.S. Financial Stability Oversight Council (FSOC) decided that financial distress at the insurance giant no longer posed a threat to U.S. financial stability. The Council voted to remove AIG from a list of systematically risky institution, often known as those that are ‘too big to fail.’

Removal from this status would mean AIG is now free from supervision from the Federal Reserve’s Board of Governors and strict prudential standards including tougher capital requirements.

On September 16, 2008, in exchange of the money it pumped into the company, the U.S. government received nearly 80% of the firm’s equity. For decades, AIG was the world’s biggest insurer, a company known around the world for providing protection for individuals, companies, and others. But in September, the company would have gone under if it were not for government assistance.

Read on to learn what caused AIG to begin a downward spiral and how and why the federal government pulled it back from the brink of bankruptcy.

High Flying

The epicenter of the near-collapse of AIG was an office in London. A division of the company, called AIG Financial Products (AIGFP), nearly led to the downfall of a pillar of American capitalism. For years, the AIGFP division sold insurance against investments gone awry, such as protection against interest rate changes or other unforeseen economic problems. But in the late 1990s, the AIGFP discovered a new way to make money.

A new financial tool known as a collateralized debt obligation (CDO) became prevalent among large investment banks and other large institutions. CDOs lump various types of debt—from the very safe to the very risky—into one bundle. The various types of debt are known as tranches. Many large investors holding mortgage-backed securities created CDOs, which included tranches filled with subprime loans.

The AIGFP was presented with an option. Why not insure CDOs against default through a financial product known as a credit default swap? The chances of having to pay out on this insurance were highly unlikely, and for a while, the CDO insurance plan was highly successful. In about five years, the division’s revenues rose from $737 million to over $3 billion, about 17.5% of the entire company’s total. (Read Credit Default Swaps: An Introduction to learn more about the derivative that took AIG down.)

One large chunk of the insured CDOs came in the form of bundled mortgages, with the lowest-rated tranches comprised of subprime loans. AIG believed that what it insured would never have to be covered. Or, if it did, it would be in insignificant amounts. But when foreclosures rose to incredibly high levels, AIG had to pay out on what…