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We had a lifetime health club membership...well the health club went belly up & there were so many creditors that there simply were not enough assets to satisfy everyone’s claims—like trying to get blood from a turnip...not gonna happen. However, if the someone else had been writing policies against the health club ever going bankrupt, then they would be out lots of money—there were many unhappy campers

Not a bad example, so what happened to the money? With the MBS, there are defaults and there were profits skimmed off the top when the securities were created. But those numbers are roughly 10's of billions and billions respectively, yet the writeoffs are 100's of billions and will be trillions before it is over. The answer to the missing money is that it never existed.

The stock market in 2000 is another good example, everyone's shares were worth trillions, but that was paper wealth, not real wealth. In the case of your gym, while you put your hard-earned wealth into the membership, your neighbor may have put it on their credit card, paid off the credit card with a home equity loan, gone underwater on the house, and defaulted on the loans. That's the nature of a credit bubble, it is the predominance of paper wealth over capital.

As credit creates leverage (your neighbor using the paper value of his house to obtain loans), credit bubble contraction causes deleveraging. In the case of your neighbor who owes more than the house is worth, the bank takes the house, auctions it for half price, then takes other money owed from your neighbor's other assets like bank accounts. Let's say another neighbor uses his 100k HELOC from bank1 for downpayment on a property downtown and borrows 900k from bank2. The market turns down and his house is underwater. Bank1 takes the house and sells at a loss, just enough to pay the primary mortgage but not the HELOC.

Now the guy owes 100k to bank1 and 900k to bank2. Bank2 decides the guy is a poor credit risk and calls in the loan. The property sells for 800k in a fire sale. Now the guy owes 100k to bank1 and 100k to bank2. But what's this? He has 200k in membership deposits, guess who gets that money? There is potentially real money that disappeared, not just credit.

The problem is worse with derivatives. Money cannot be created from thin air without dangerous leverage. At least with banks and other institutions, the regulators can enforce risk and reserve requirements. For AIG, the State of NY regulated their insurance business and enforced requirements on reserves based on risk. But once AIG got into the business of CDS, the regulators were completely ineffective. They approved the business but AFAIK, did not perform any independent risk analysis. That meant that AIG could create and book profits on income streams that would not exist in a downturn. At that point, the income stream would disappear and they would owe whatever the default losses were.

In your health club case the "real money" is your own membership as you point out. In the case of AIG, the real money is the reserves for their other insurance business and the collateral for a large amount in loans (about a trillion). Your own health club payment was real, not borrowed, it came from your earnings and was spent on consumption. Your neighbor's payment was not, it was borrowed and because the money is gone, he can't get it back to use to keep his house. That where deleveraging creates a ripple effect in the economy.

In the case of AIG's trillion in loans, a lot of that is in the form of securities owned by other financial and nonfinancial entities, used to leverage other loans or provide collateral for economic activities. Some of those securities could be owned by the health club neighbor who wakes up one morning and finds that his AIG bonds are worthless. Then he gets a phone call from the bank.