$20 Billion, $40 Billion, $80 Billion . . . Do I Hear $160 Billion? . . . Going . . . Going . . .

Not a bad narrative of the last couple of days at AIG, if you need a basic introduction to what just happened.

But if the narrative is correct, then I think there’s a real question whether the Feds did the right thing.

I don’t know enough about what AIG looked at from the inside to be sure, but here’s what I’m thinking.

AIG FP – the unit that wrote credit derivatives protection on a variety of structured credit vehicles like CDOs – was a non-insurance unit under the holding company. The holding company is the issuer of the common stock as well as the unsecured public debt. And the holding company is what was downgraded by the ratings agencies and that needed to come up with billions of dollars of collateral to post once they were downgraded.

If AIG were to fail, it would have had a variety of repurcussions. But I’m not clear why a failure of the holding company would necessitate a failure of the insurance operating companies. And if the government – presumably led by the New York insurance regulator – stepped in to protect the insurance operating companies, that would have protected a wide variety of stakeholders in the health of AIG, both domestic and international.

Who wouldn’t it protect? The owners of common stock – but these guys shouldn’t be protected, and have been virtually wiped out already by the intervention that gave the Fed a 79.9% equity stake and saddled the firm with $85 billion in structurally senior debt. The owners of unsecured or subordinated debt – but these guys are also not quite bailed out in the current scenario, as AIG senior unsecured debt now trades below 50 cents on the dollar, and anyway it’s not clear why it’s important to protect AIG senior debtholders while wiping out, say, Fannie and Freddie preferred holders. At a minimum, it sounds ad-hoc.

And it wouldn’t protect derivatives counterparties, and this is where the rub is, because these are the same investment banks that are teetering on (or over) the edge of bankruptcy.

This looks to me like it might be a stealth bailout of the counterparties of AIG FP, with the policyholders as a political stalking horse. I’m not sure you needed to save AIG’s holding company (assuming that has been accomplished) to protect policyholders. And if you could have saved the insurance subs and their policyholders without bailing out AIG, that was probably the right thing to do, because it is better to come up with a genuine systemic solution to the metastasizing mortgage mess than to try to keep the system limping along with rolling bailouts.

Again, I want to be clear: I don’t really know enough about the shape of AIG’s business to be very sure of my instincts here. And on the pure level of market confidence, an AIG failure at the holding company level would have been very bad. And, finally, this decision was obviously made in great haste, without adequate preparation by the government, so if the decision was wrong I cut Paulson and Bernanke a great deal of slack. But I don’t have a good feeling about it.

Finally, let me be clear about one other thing: a systemic solution would require more taxpayer money, not less. But there would be more hope of structuring it fairly, and that matters.

Update: I see that Paulson is now talking about an RTC-style intervention, such as I’ve been expecting for some time and such as Barney Frank and Chris Dodd talked about recently as well. The market is melting up on this news as I type.